As the country looks to emerge from a year of lockdowns and restrictions, the UK government has adopted the “build back better” mantra. In the coming months SME specialists, Seneca Partners will provide insight into some key themes facing businesses as they look to recover from the effects of the pandemic.
In the first of our Build Back Better series, we examine how those businesses who have ambitions for growth should deal with the equity versus debt conundrum when seeking additional capital.
Is equity or debt the best option for scaling businesses?
Thinking back to my university days, I recall studying the theory on the optimal mix of debt and equity funding in order to reduce the cost of capital for a business. In practice, the debt versus equity debate depends more on business specific factors and therefore a more pragmatic approach is required because each has pros and cons.
What’s evident is that for good businesses and good business opportunities, there is currently a wide array of capital available. With debt funding ranging from retail banks offering government-backed support, asset-based lending (ABLs), through to alternative debt funds. In terms of equity funding, this can range from angel investors, crowdfunding, a range of venture capital and private equity options, ultimately through to the public markets.
Although debt and equity have different characteristics within each of the above categories, the fundamentals are characterised essentially by two factors, dilution and repayment.
Debt, on the whole, enables you to avoid dilution and maintain control of your business. However, this comes with the cash flow pressure of defined repayment of both principal and interest.
Conversely, equity has no (immediate) repayment term, but you dilute your own equity stake and are very likely to have to sacrifice an element of control.
The general consensus is that equity is more expensive than debt, as equity generally carries greater risk for the funder, who will in turn expect a higher return for this risk.
Cost however should not be the only factor considered.
Consideration should also be given to the life cycle stage of a business, its existing capital structure, the sector it is operating in, what the funding is required for, and whether you have debt capacity or collateral and sufficient cash flow to service debt. Early stage or pre-profit businesses will not have cash flow available to service debt and may have little option but to go down the equity route.
Putting the case for debt
Debt is often the preferred option, particularly when used for a specific purpose or when looking for funding for a defined term. Terms available can be monthly repayments, asset-backed facilities through to a single bullet repayment. As long as free cash flow can easily cope with the required repayments, lenders will generally not interfere in the decision making or running of the business.
Debt funding also has the advantage of being quicker to arrange, but, in the context of businesses which have long term growth ambitions, there may come a point where debt capacity tightens up, especially for earlier stage businesses. Viewed simply, debt should usually be accompanied by stable cash flow.
Putting the case for equity
Equity can be regarded as more “permanent” capital and, without the burden of debt repayments, any cash surpluses can be retained in the business to finance growth. Much depends on what the end goal for management is and how ambitious their growth plans are. Often, equity may involve multiple funding rounds or “follow on” capital at higher valuations as each stage of the growth plan is achieved.
It is also the case that many business owners value the input and guidance of equity funders who will often provide strategic support, direction and quite often a “black book” of contacts alongside the funding itself. The trade-off is that shareholders will be required to dilute their equity and management will usually be more restricted in the decision making and control of their businesses – depending on whether they have retained a minority or a majority stake following the equity injection.
When debt funding worked best…
In the case of one of our manufacturing clients, importing raw materials and converting to partially finished and finished stock was failing to keep pace with demand. On the face of it, this is a great problem to have. Gearing up production and how to finance required capital expenditure (capex) of circa £5m was challenging and they sought advice on how best to achieve it.
Numerous equity offers had been tabled and although these were only minority stakes, the terms attached were restrictive and took away significant control. The business had an existing bank overdraft facility but was not certain it could obtain a further increase to the required level. Setting a financial structure for the business was important in this case.
Separating out capex for the acquisition of additional warehousing and plant from the growing working capital needs, by agreeing a flexible stock and trade receivables facility, provided the solution. This made best use of the company’s own assets on more advantageous terms and without any loss of control for management.
When equity funding worked best…
When approached to consider funding for acquisitive growth, it was a clear situation of management needing to reach and meet the vendor’s asking price and “cash out” requirements. The business was in the professional services sector and had few tangible assets that would appeal as valid security for traditional bank funding. With banks generally happy to consider 2x EBITDA (earnings before interest, taxes, depreciation, and amortisation) multiples for cases of this nature, this did not provide the funding required to meet the vendor’s requirements. The acquirer also had an offer of 4x EBITDA from a debt fund, albeit at much higher cost with an equity warrant attached which enabled the acquirer to get much closer to the figure required by the vendor.
Having considered the merits of equity partners and approached those we thought would fit the bill, we were ultimately able to agree a higher level of equity funding without the onerous repayment terms which would have been extant on the debt deal, enabling the acquirer to meet the vendors expectations. The sector experience and knowledge brought to the table by the equity house was also a very positive attribute in the eyes of the management team.
The best of both…
Whether it is the dilutive effect of equity or the repayment or debt capacity for a business, the terms of support behind each option are likely to have significant long-term implications. Each business is unique in both circumstance and structure, so there is no single answer which adequately addresses whether a business should opt for debt or equity funding above the other. The two are not mutually exclusive and it’s likely that debt and equity in combination will be a feature of many growth companies.
The variety of funding types and sources available in the market are both increasing and innovative and are likely to be even more so as we build back better. Too often though, we encounter businesses which have taken funding on board without it being appropriately structured for their own growth aspirations, therefore taking relevant and specific advice is always to be encouraged.
Essentially, the devil is in the detail and understanding and accepting terms for any funding line which are workable, not onerously restrictive and allow the business to continue its journey are vital and compelling reasons why advice ought to be obtained.
Coming up next in our Build Back Better series, we take a closer look at how more traditional family businesses can continue to grow using fresh capital to replace “friends and family” shareholders
Ian Dawson is a director in the corporate finance and advisory division of Seneca Partners