Debt v Equity Finance for Expansion

Entrepreneurs have largely two expansion fund options: debt, where you take out a mortgage on the future; or equity, where you sell a portion of the family silver. Choose the right one, structure the deal appropriately, and your venture will thrive.

How you raise money to fund your business can be as important as the projects and strategy for which you want the finance. Equity, where you surrender some ownership but do not have to pay interest, or debt, where you keep your hands on the whole of your company but must pay regular interest in good times and bad, are the principal alternatives. Each has its attractions and drawbacks, which can vary according to the type of business you are running.

Winning support from an equity backer, whether an individual ‘business angel’ or a specialist equity company, can be time-consuming and expensive and means giving away part of what you have sweated blood to create.

Loan finance is usually simpler, quicker and cheaper to obtain, provided your business has assets and/or cash flow on which to raise it or you are in a position to supply the necessary assets and guarantees yourself.

On the other hand, the primary concern of lenders is ensuring you deliver steady payments of principal and interest. They are therefore unlikely to have the same commitment to seeing your business through tough times and key milestones as equity backers whose interests are – or should be – essentially the same as yours, and are therefore keen to supply advice and practical help.

An array of options

A range of financial tools is on offer for companies wishing to grow. Banks and other lending institutions will provide asset-based loans and facilities to established businesses with a track record.

They, and specialist finance groups, will also provide funding on the security of cash receivables or invoices or, at a price, ‘mezzanine funding’, advanced on expected cash flow and prospects, which ranks behind asset-backed lending in the creditors’ queue and charges more. Specialist private equity firms, individual business angels and others will take direct equity stakes.

It is a case of matching the type of financing you seek with the type of business you run. As Russell Warner of Eurofactor puts it, ‘if yours is a business with a high element of technology and intellectual property, involving research and development, then it is appropriate to use equity finance.

‘It is different with a sales-led operation, with a sales growth plan. Then you can use the assets in the balance sheet to raise debt.’

Many private equity specialists shun deals below £5 million, though private angels do not, and often insist on set minimum internal rates of return, such as 15 per cent. If your business is robust enough, raising smaller sums on the AIM junior stockmarket or the OFEX private share market is possible in the right financial climate.

Of course, equity investors need the prospect of eventually cashing in their chips through some kind of exit. This could be selling to new investors – easier if the company is publicly quoted somewhere – or a trade sale to another company.

Some equity providers will include a convertible loan in the financing package they offer, thus obtaining a ready income from the outset, which can be turned into an equity stake if the borrower achieves the hoped-for growth. These convertibles can carry high rates, such as seven per cent over base rate, currently 4.5 per cent.

Work out the lay of the financial land

At present, banks and other lending institutions are awash with cash and lending to businesses on easier terms than have been seen for years. But that does not necessarily mean that 100 per cent debt funding is always the best course.

Gerry Hoare of Bank of Ireland arm Enterprise Finance Europe says some big banks are willing to provide loan facilities of up to £20 million to companies with £1 million net worth. ‘Ten years ago a bank would only lend £3 million.’

This willingness to lend can be a double-edged sword. Charles Whelan of specialist adviser HW Corporate Finance says banks are now readily lending seven times profits on big deals and three times on lesser ones. He vividly recalls arranging a £12 million management buy-in for a talented entrepreneur funded by debt and vendor loan notes repayable after three years.

The entrepreneur was loath to give away any significant part of his business to other people in exchange for equity funding and, as the enterprise grew rapidly, his determination to ‘do it all by debt’ seemed vindicated. Later on, however, there was a dip in the market, he found he could not meet the bank’s repayment schedule and to repay them he was forced into a distress sale of the venture he had created.

Risks you can’t control

Another risk for the head of a company seeking growth through loan finance is not that his or her company or market meets problems, but that the lending institution faces difficulties elsewhere. These problems, unrelated though they are to specific existing clients, can cause it to cut back on future lending even to the best performing clients – as, of course, can wider problems on the overall financial and economic scenes. And then of course there are interest rates, which are historically low at present. But, if they were to revert to levels seen in some previous decades, the burden of debt could become menacing and fixed-rate deals much costlier to arrange.

Taking the right route

Richard Ellis of Business Link for London, which recently helped former New York magazine chief Huw Gwyther launch a new magazine for the rich called Wonderland, spells out the choices for smaller companies deciding what financing route to try. Provided you have a credible business plan ‘you could get an overdraft facility on the same day,’ he argues.

‘The arrangement fees are relatively cheap and you keep control of the business too,’ he stresses. The key is your company’s ability to maintain repayments, at rates which others suggest could be from two to five per cent above bank base rate.

But, whatever fancy multiples lenders are agreeing with larger companies, at the small end, argues Ellis, it remains hard to obtain bank loans worth more than the present net worth of your company. ‘Once your funding requirements exceed that, then you will need equity.’

And this, he maintains, can be costly and is likely to take ‘two to three months at best’ to arrange. ‘Unless you get money from a family member or someone else who does not need to do much checking, you will find business angels want to check the claims you make and get accountants to go through the process of due diligence, going through the company in considerable detail.’

The investment will most likely involve legal contracts, such as shareholder agreements, and attendant legal fees and, if there is a person or company arranging the deal, a success fee, to boot. Ellis reckons combined fees for a £40,000 to £50,000 equity deal could be from £8,000 to £10,000.

Smaller companies can seek to take advantage of the Small Firms’ Loan Guarantee Scheme. Under this, the Department of Trade & Industry guarantees loans of up to £250,000 under certain circumstances.

What lenders and backers really want

In most cases, the lender’s chief priority is seeing that the loan is serviced and repaid, whereas you need to pay dividends to equity holders only when the company can profitably afford to do so (and not always then). Moreover, loan providers do not simply leave you alone to get on with it, but usually require regular (say, quarterly) audits to see how their interests are being safeguarded.

The equity backer wants the business itself to thrive and is often ready to help with advice on strategy and governance, contacts and other forms of help. These might seem irritating or even threatening to a proudly independent-minded and self-confident boss but will be welcomed by many others.

This can involve bringing in a knowledgeable non-executive director. If you can swallow your pride, ‘there is a pool of very experienced people out there’ keen to play this role, maintains John Hudson of Sand Aire Private Equity, an active player in this field, now itself in the process of being bought by mid-market private equity house Dunedin Capital Partners.

A mix can be best

The presence of a significant – and credible – equity participant can give comfort to banks deliberating whether to lend money to a young business. Whelan recalls how, when HW was trying to arrange a £400,000 management buyout recently, all the banks refused to lend until HW found some business angels to invest £100,000, whereupon the banks decided they were happy to lend the remaining £300,000.

An able and supportive equity backer certainly played a crucial role when entrepreneur Bob Blunden was asked by the founders to take the chair at Maidstone-based CET Group, which specialises in materials for road contractors and site investigation and subsidence checking for insurance loss adjusters. They hammered out a £4.5 million five-year plan, involving acquisitions and organic growth, which took turnover to £13 million and likely current profits to £1.5 million.

As Blunden switched roles to chief executive, the next challenge was how to realise value for the original shareholders and take the company to the next stage. He went for a management buyout, advised by accounting group PricewaterhouseCoopers, and assembled a team to carry this through.

Sand Aire won a beauty parade to handle the deal, having ‘clearly done more homework than anyone else’, according to Blunden. Sand Aire procured £5 million of equity, leaving it with a small voting majority, and a £6 million six-year loan from HSBC.

CET is now looking for acquisitions, with the active support of Sand Aire, which had been bringing potential takeover candidates to the company well before the buyout deal. Actively engaged in CET with strategy on all fronts, Sand Aire, whose director Hudson has a clear rapport with Blunden, is ‘totally flexible over the timing of its eventual exit’ by flotation, acquisition or some other route.

This flexibility is, says Blunden, rare among private equity houses. ‘They often have a fixed timetable, saying, “out in five years”.’

A multiplicity of deals

Deals come in all shapes and sizes. Earlier this year, Eurofactor backed a merger of Liverpool-based Polythene Industries, a ‘non-core’ but successful specialist producer within a PVC combine, and cash-generative but ill-organised Oxfordshire plastics trader Polyplast.

David Rawle, head of the management team, and other players wanted to cede as little ownership as possible and Eurofactor put together a £2 million package representing 100 per cent of eligible debtors. The business is now on track to lift turnover from £10 million to £12 million.

In the West Midlands, Richard Quarmby and Adrian Carr, respectively managing director and finance director of fast-growing £10 million petrol station forecourt designer TQ IPS, wanted to buy out Jane Quarmby, the company’s founder and Richard’s stepmother. The duo also wanted to finance a £13 million contract to build 20 new petrol stations for supermarket chains.

Enterprise Finance Europe arranged a flexible invoice discounting facility. This was to finance both the buyout and future growth.

Another business backer, NBGI Private Equity, recently obtained a £4 million mezzanine loan from South African-owned City group Investec as part of a £40 million funding package for a management buyout of Stirling-based Superglass Insulation, a leading glass fibre insulation manufacturer, from its parent, Encon Group. Superglass managing director John Smellie, who led the buyout, says ‘these new arrangements will enable the company to invest in a range of new, state-of-the-art product-handling equipment, which will allow us to increase capacity and efficiency.’

What type of finance is appropriate and available can depend not only on the nature of your company’s business but also on its age. ‘Debt may be cheaper,’ comments Whelan, ‘but smaller companies can find it hard to raise, with too few assets and, as yet, too little cash flow. Often a business starts with an entrepreneur putting in £25,000 to £30,000, then moving to factoring, then to equity and then to debt.’

Marc Barber

Marc Barber

Marc was editor of GrowthBusiness from 2006 to 2010. He specialised in writing about entrepreneurs, private equity and venture capital, mid-market M&A, small caps and high-growth businesses.

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