Raising Business Finance - Debt versus Equity

In order to expand, it's necessary for business owners to tap financial resources which typically fall into two categories – Debt or Equity. In this article, James Conduit, Corporate Partner, explores the pros and cons of each.

Debt financing:

Involves borrowing money to be repaid plus interest, while Equity involves raising money by selling an interest in your company. Debt also has a set time when the finance must be paid back, a set interest rate, and typically fixed or variable payments (capital and interest) that that need to be met each month. Many entrepreneurs prefer to use debt funding to facilitate business growth as there are no hidden costs and no need to give up any shares in the company. It also allows the owner to keep control of their business rather than having to negotiate, and incur the cost of, buying out an investor years down the line when business is going well to regain control.

Equity financing:

Involves selling a stake (i.e. shares) in the company to an investor or individual (through a deal with a venture capitalist, a private equity fund, an angel investor, or crowdfunding platform) in return for receiving an equity investment to expand and grow the business. Equity funding allows the business owner to distribute the financial risk among a larger group of people. You won't have to repay in regular instalments (particularly when your business is not making a profit) or deal with steep interest rates. If the business fails, none of the money needs to be repaid. Instead, investors will be partial owners of your company who are entitled to a portion of its profits, are likely to have a seat on the board of directors, will want to be provided with regular reports, and will have a say in key business decisions/actions which can not be taken without investor consent.

Debt versus Equity - which is best for your business and why?

The simple answer is that it depends. The equity versus debt decision relies on several factors such as the current economic climate, the business’ existing capital structure, and the business’ life cycle stage, to name a few. Whilst they are very different things, this doesn’t have to be an either/or choice - a combination of both debt and equity funding might be best for your business at times. But it pays to know what you’re getting into with each.

Equity Finance:

Pros/positives

Cons/negatives

By issuing shares the business will receive cash investment at no instantaneous cost to it aside from legal paperwork and other miscellaneous deal costs. Investor can bring plethora of knowledge, experience and contacts to benefit business in terms of its growth, development and expansion and its internal operations, management, administration, systems etc. Investor’s years of experience in a specific sector can help owners identify and solve problems before they arise. Investor is likely to have capital on hand to make further investment and scale up business. Company does not have to pay monthly capital and interest payments so can use this extra cash revenue to further invest in business to grow and develop it. Investor can support businesses in sectors that traditional debt lenders avoid/dislike. Investor will expect dividends and returns further down the line when business is profitable (rather than regular monthly debt repayments of fixed or variable amounts) If the business fails, the investor losses their money rather than you personally losing money or assets if you have guaranteed repayment to be bank or provided personal assets as security to the bank.

At some time in future if business is doing well when you will want to negotiate to buy shares back from investor. Buyout funding likely to come from business itself and often more costly than you think. Future buyout price/costs are unknown and cannot be forecasted in initial investment. If investor is not bought out, they will continue to take profits from a successful business from the same investment they had made quite some time ago. Giving up equity in business will usually result in giving up voting rights to the new shareholder which can ultimately influence the future management decisions of company in favour of the new shareholder, and thus, interrupt your original vision. To secure investment you will need good financials, some semblance of working product or service, an attractive business plan, a qualified/strong management team, and a sold foundation to back it all up. Investment pitches require a lot of time and effort. Investment process will involve lawyers and some initial costs. You’re not only owner so exiting business is not always easy. You will have to provide regular reports to, and attend regular meetings with, investor, and obtain consent of investor to certain key business decisions/actions. Big expectations - investor wants to be sure you will grow the business and make them money.

Debt Finance:

Pros/positives

Cons/negatives

You retain 100% ownership and 100% in control/charge. Straight forward but not always speedy. Lender is entitled only to repayment of loan plus interest and has no direct claim on future profits of business. If company is successful, owners reap a larger portion of the rewards than they would if they had sold shares to investor in order to finance the growth. Interest on debt can be deducted on company’s tax return, lowering actual cost of loan to company. Company not required to send periodic reports and financial information to, or hold regular meetings with, shareholders, or seek shareholders vote/consent before taking certain business actions/decisions. Widely available may even roll in other banking and credit services plus insurance. No regular reporting obligations. No obligation once the funding is repaid. Only expectation from lender is that loan will be repaid with interest. Terms are usually clear and finite - regular monthly repayments with fixed or variable amounts so you know exactly where you stand for forecasting/budgeting. In terms of transaction process and deal costs, debt finance is usually less complicated and less expensive.

Unlike equity, debt must at some point be repaid. Cash flow and revenues are required to repay regular monthly loan and interest payments which must be budgeted for (no flexibility to repay in varying amounts over time based on the business cycles). Interest is a fixed cost which raises company’s break-even point. High interest costs during difficult financial periods can increase risk of insolvency. Companies too highly leveraged (i.e. large amounts of debt rather than equity) often find it difficult to grow because of the high cost of servicing debt. Repayment and interest terms can be steep and typically payments start first month after loan is advanced, which can be challenging for start-up business not yet on firm financial footing. Debt instruments often contain restrictions on company’s activities preventing management from pursuing alternative financing options and non-core business opportunities. Larger a company’s debt-equity ratio, the riskier company is considered by lenders and investors, whereas a business is limited as to the amount of debt it can carry. Usually required to pledge company assets to lender as collateral, and owners often required to personally guarantee repayment of the loan plus interest and pledge personal assets/property. Harder to obtain if business is start up/early stage, has poor credit history, has no security to pledge, or is in a sector which debt lenders don’t like/avoid. Potential for personal/family losses if it becomes impossible to repay loan. Owner is risking their credit score, their personal assets/property, and their previous investments in the business. Ultimately may result in owner’s bankruptcy. Whereas equity investor loses their money (not yours) if business fails.

The Sills & Betteridge LLP Corporate Team have extensive experience working with businesses of all shapes and sizes, across all sectors, looking to raise finance for all kinds of purposes. We also for local and national private equity houses, venture capital funds, business angels, banks, asset based and other private lenders, on the full range of equity investment and debt lending transactions. Our experts see it from both sides and can help you navigate and assess all your funding options so you can make the correct informed decision which is best for your company.

For a free informal meeting or chat contact James Conduit, Corporate Partner on JConduit@sillslegal.co.uk or 01522 542211.