Funding for growth: Debt versus Equity

The reality is that your business may require a cash injection at some point to fund its growth ambitions. How you go about doing that will throw up a host of options, but it will boil down to the age-old question of debt versus equity.

Do you want to borrow to fund your ambitions or do you want to relinquish equity in your business to do so?

To provide an insight into both funding options and the trends emerging around them we spoke to key figures in the market.

Equity investment

Show likes Dragon’s Den have shone a spotlight on the cut-throat nature of businesses receiving investment, but the investor scene is much more demanding, as Andrew Barratt – Director at Shaw & Co – explained: “Dragon’s Den is considering very small investment in early stage businesses. As such, an understanding of the market, the proposition and the people behind the business is all that is really needed to decide to support or otherwise.

“The truth behind Dragon’s Den, and Angel groups that operate in a similar way, is that a good number of businesses that get offers fail to secure the offer as they fall foul of the basic financial due diligence that follows.

“If you are looking at raising several million pounds, the process is significantly more involved, including the preparation of detailed marketing materials and financial forecasts and this is how you will need to operate in the equity investment space.”

60% of £10m

Regarding the advantages of receiving equity investment ahead of growth through debt, the principal of 60% of a £10m instead of 100% of £5m holds some stock.

This is because investors are incentivised to grow the business and achieve an exit which gets them their money back.

As Andrew explains – they will also be able to provide strategic guidance: “Whether debt or equity is right for your business will always be case specific. However, in general terms using leverage (debt) will give better returns for shareholders and if a business has the capacity to borrow, this if often the right option.

“That said, debt comes with a servicing cost and can have a binary outcome in the circumstance where a business has insufficient cash to meet this. Equity is much more flexible and will take a longer-term view.

The providers of equity are regularly more involved and are aligned to help grow and develop a business over the long terms can offer strategic advice and contacts. Whereas the providers of debt are incentivised to protect their capital and ensure their margin is paid.”

Regarding when equity provides a better option for businesses, David Hall, who is Managing Director at YFM Equity Partners commented: “One way to look at this is to think of debt as the fuel and equity as the oxygen that provide the energy and thrust to a business.

“Equity only works if the business grows in value, so its purpose is to provide funding over and above the day-to-day needs of the business, to make that additional investment to support growth or change and provide the headroom and breathing space to take those strategic decisions which have a medium or long-term payback.”

Angus Grierson, who is Managing Director of LGB Corporate Finance, says it’s worth considering the cost of equity now: “Equity can be preferable as it generally does not require fixed repayments and gives business owners more flexibility in managing the business and allocating capital in the short term. Equity is also relatively cheap now. While you will be exchanging ownership of your business and decision-making power for growth capital, the right shareholders can bring valuable strategic advice, industry experience and connections.”

Debt

Clearly equity investment brings with it a combination of funding and strategic advice and a plan for growth.

However, debt funding can be a better strategic option for businesses says Alexander Rimmer – who is Business Development Director at SME Capital.

He commented: “Being able to offer companies a flexible debt solution to help them grow their business is generally a much more attractive proposition that having to give away equity. Often companies need an injection of capital to help with growth and if cash flows are steady – and able to service debt over a 3-5-year period – then to be giving away 30+% to an equity provider isn’t the best option for management teams and business owners.

“You also hear stories of companies taking on equity funding and a few years down the line, people’s strategy and opinions regarding the business change, leading to a falling out between the management and the equity provider. This can result in disruption in the business.”

Value added

Gary Hemming, who is Commercial Lending Director at ABC Finance, says that funding growth through leverage is easier than ever for scale-up businesses – with no need for daunting meetings with bank managers any more.

He explained: “Unless there is a real value add from an equity partner outside of the cash injection, such as expertise or contacts, an unsecured business loan is a sensible first port of call for business owners. No doubt – business loans can be an excellent option for those looking to raise capital and offer the advantage of allowing you to retain full ownership of your business.”

One of the benefits of taking on debt can be the speed of decision making. Thanks to advances in technology, you can get an answer quicker than ever before.

This has seen a proliferation of alternative finance providers offering business loans.

Rob Straathof is CEO at Liberis. He commented: “With constant advancements in technology, financial regulations and new waves of thinking, the landscape of modern business is constantly evolving. Open Banking is now emerging within the financial services industry and just a few weeks ago, we successfully processed our first funding application to a small business via this technology.

“Open Banking has the potential to empower better lending decisions and add convenience to the payment process for UK small businesses of all sizes. With this use of smart data, we will see an increase in the number of businesses, previously turned down by banks, who are now able to access credit and receive funding. A significant milestone for small businesses as well as the financial services industry.”