Businesses at growth crossroads – either scaling up or building out – often need that injection of cash to catalyse success. With an increase in net lending and greater diversity among alternative lenders, the overall conditions for businesses seeking debt finance have improved in recent years.
The prominence of angel funding and venture capital firms have also propelled equity financing to the mainstream over the past decade. But which type of financing suits your business needs the best?
85 per cent of UK businesses use debt to finance their businesses, according to figures from the European Commission. One form of debt financing are traditional secured loans, like those offered by banks. These loans are usually repaid in monthly installments and require a personal guarantee on the part of the borrower, such as inventory or real estate, to stand as collateral if the borrower can’t pay back the loan. Growth companies typically need a proven business model, healthy cash flow and a strong track record to secure debt financing. But the rise of FinTech companies like London-based start-ups, Everline and ezbob, have lowered the barriers entrepreneurs traditionally faced in accessing finance. Any director, owner or partner of a UK registered company turning over a minimum of £10,000 and over 12 months of trading history can access finance in minutes through these platforms.
There are many advantages to debt financing. Primarily, the lender has no say over your business, and once the loan is paid, your relationship with the financier ends. Considering that loan payments are a fixed amount, it is easy to forecast expenses and have an upperhand on managing your cashflow. According to Adam Tavener, chairman of the Alternative Business Funding (ABF) Group, debt financing is the most straightforward option for growing businesses. “For a successful business model, debt is always cheaper as giving away equity at an early stage in a business that subsequently goes on to succeed is probably the most expensive money you will ever access. As the business grows, and assuming that the assets are available to do so, a debt based approach can be scaled almost infinitely,” he told Growth Business.
However, since debt is based on your future ability to repay the loan, factors like a recessionary economy, or unexpectedly slower business growth, can hamper your company’s cashflow. “A debt based funding model usually comes with some servicing requirements, not always easily adhered to in early stage business where cash is tight. Debt based funding for early stage businesses will almost always require some personal security from the business founders who are therefore assuming the whole of the business risk,” Tavener added.
Debt financing may be better suited for businesses past the startup stage, where sustained growth is a priority. “In general, small business owners should stretch their debt as far as they can, to avoid any dilution of equity. Debt funding is almost always the most cost-effective option, especially in this prolonged period of low interest rates,” Mike Grayer, corporate finance partner at accountancy firm, Menzies LLP said.
For growing businesses, Grayer suggests a possible hybrid approach: “A combination of debt and equity could provide the balance, and financial clout, required to successfully expand business operations or enter new markets.
“If entrepreneurs are set on bringing a product to market quickly, then the issuing of shares, accepting the dilution of equity, may be the only option. In this case, business owners should vet potential shareholders and where possible exchange a stake in the firm in return for the promise of boardroom expertise or mentoring from investors.”
Attracting an equity investor that is aligned with your business, and willing to take a long-term view in your growth approach can catapult business growth. A major advantage of equity financing is that the investor takes all of the risk, so if your company fails, you won’t have to pay the money back. Without any loan payments, your business will be cash-rich through this method as well.
“High potential start-ups have a great deal to gain from equity investors, especially those investors who understand how much value needs to be built early on before a particular type of firm can achieve its ambitions,” Bivek Sharma, head of KPMG Small Business Accounting, said. According to Sharma, early-stage businesses can’t afford being saddled by debt as the pressure to turn profit from the get-go can cap a firm’s value and stifle cashflow.
“Some of the newer equity platforms offer real benefits, with peer-to-peer equity platforms well suited to early stage businesses, especially those that do not want investor input with regards to the direction of the business. Amongst all the FinTech excitement it’s also worth checking out traditional equity routes like business angel networks and venture capital funds. The extra capital can give small businesses resources for marketing and talent acquisition, leaving them less vulnerable to competitors, as well as lessening a business owner’s personal risk,” he told Growth Business.
The downside of equity financing can be crippling for some entrepreneurs. In order to gain the funding, investors will own a percentage of your company, share your profits, and have a say in every decision affecting the business. The only way to regain control over the business is to buy investors out, which is likely be more expensive than the original investment.
According to Diane Yarrow, partner in the commercial and corporate team at Gardner Leader law firm, the best option for those with the luxury of choice, depends on the price entrepreneurs are willing to pay for access to finance.
“Whilst interest will need to be paid for a limited period on a debt, an equity investor will be involved in the company until the investor sells their equity stake in the company. That means the business owner has to get comfortable with relinquishing control on an ongoing basis and with sharing the profits of the company with the investor until there is an exit,” she explained. “Further, the interest paid on debt is agreed up front and while profits will hopefully grow so will the amount that is paid as a dividend to the investor as compensation for the money they invested to allow that growth to happen.”
In the long run, equity financing requires an iron-clad business plan, according to ABF’s Adam Tavener. “There is only so much equity you can give away, however, so usually (all too often, in fact) by the third round of funding the founders of the business have been watered down to insignificant levels and are, effectively, working for someone else. A look at the ownership profiles of many of the new FinTech businesses, whether it’s crowdfunding, peer to peer or aggregator sites illustrates this point nicely.”
The bottom line
The type of financing you require depends on your goals and stage of growth. The doors to venture capital are usually closed for early-stage businesses, and debt financing can pose a problem for businesses that require large cashflow.
See also: Debt vs Equity – Funding Options CEO Conrad Ford explores the eternal funding question of debt vs equity.