Debt vs Equity Finance: Which is the Better Option to Fund Growth?
For those seeking finance for growth, the question will be – can I raise debt funding or shall I seek equity? Both have their advantages and disadvantages. Here are six factors entrepreneurs should take into account to help them weigh up the pros and cons:
Despite the current climate, there remains a good level of debt and equity available, however, debt financing costs have risen as lenders factor in increased risk in the economy while the price paid for equity has also seen adjustment. Therefore these costs have to be weighed up against the enhanced future value the funding would create.
Debt funders will want to assess the performance of a business and stress test it to satisfy themselves that if there were unforeseen circumstances, the loan could be repaid. In some cases – in particular early-stage businesses with partial or unproven growth models – equity funding may be the best option.
- Ownership of the business
Equity investors will require a stake in the business, so existing shareholders will have their stake diluted. Some entrepreneurs may be happy with this, especially given the added value external investors can bring to the business, but other founders may have different priorities. It may be a case of ‘we can see the benefits but now is not the right time’.
Owners should also be aware that in some scenarios, there may be a ‘cash call’ where all shareholders are required to put additional funds into the business – failure to do so may result in their equity stake being diluted further. It is therefore important to consider whether you could raise more money if this situation was to arise.
By contrast, taking out a loan will not dilute ownership – although funders may sometimes require an equity warrant giving them the right to buy shares in certain circumstances.
Raising new equity can be a lengthy affair and business owners should always take professional advice. Investors will want to see detailed forecasts and carry out due diligence – not only to scrutinise financial performance but really get into the bones of the business. This could include management acumen and skills, industry characteristics, market position and drivers, supply chain dynamics, IT systems and much more. Securing a loan is not as onerous and, assuming the funder has the right Information available to them, can typically be completed in eight to twelve weeks with ‘boiler plate’ documentation.
One of the attractions of equity is that the actual ‘cash’ cost to the business could be lower depending on how the funding investment is injected into the business. Whilst there may be annual equity loan interest to pay, the investment returns are more focussed on the three to five-year exit valuation, thereby allowing a greater proportion of earnings to be re-invested into the business to fund growth (and increase value). What this does mean, however, is the ‘overall cost’ of equity will be higher.
Therefore equity investment is ideal for pioneering growth companies and those with little or no income, especially when that means any spare cash can be ploughed back into the business to support its growth. Once the business model has been proven, then there is the opportunity to introduce debt with the business obliged to meet the scheduled capital repayments as well as interest payments for the term of the agreement.
Directors sometimes have concerns that equity investors will interfere in the day-to-day running of the business and they will almost certainly take a more active interest than a lender. However, loan agreements will include terms and conditions and may have covenants which must be adhered to and failure to meet them gives the lender the right to demand repayment.
- The long-term view
The question remains, which type of funding investment will give you the best outcome in the long term? By its very nature, equity investment will dilute your stake so it could affect the value you receive on exit, but this has to be weighed up against the extra value which the investment will create. Conversely, debt funding secured at a competitive rate can also help grow the business, with more value received on exit.
Ultimately what is best for one business might not be right for another. Every business evolves at a different pace therefore it depends on your circumstances and priorities. It is always worthwhile to take professional advice to weigh up the options and choose the path that best aligns with your strategic goals.
Owen is a partner of DSW Debt Advisory in the North West.