FLEDGLING BUSINESSES AND FINANCE- EQUITY VS. DEBT
Obtaining finance is the first of many hurdles when setting up a new business. But what happens once a willing lender has been found?
Typically a backer will provide the funding in the form of debt financing (a loan which must be repaid), equity financing (money in exchange for part ownership of the business – think Dragons Den) or a combination of both. In this article we look at start up businesses, consider what a backer will be looking for when they invest and the advantages and disadvantages for a business of using debt and equity financing.
Debt is a more familiar form of financing because it is often encountered in personal financial affairs, for example mortgages, bank overdrafts and credit cards. The lender will provide its customer with a loan which must be repaid and in so doing, achieve a return by charging interest on the borrowings. Both the principal sum and any interest must be repaid regardless of how the business is performing.
Debt financing might come in the form of a loan from a high street bank. However, since the financial crisis of 2008, more and more start up businesses have turned to borrowing money from family, friends and private investors who may be less reluctant to take on the risk of a start up business.
Advantages of debt
The lender does not share in the profits and so, if the business does better than expected, only the principal sum and the interest need be repaid.
The lender doesn’t have an automatic right to vote or be involved in the decision making of the company (although the loan agreement may have express provisions providing for this) and so the company may be run without interference.
Loans are debts which are tax deductible.
Loans are typically more straightforward to set up than equity finance and so are usually cheaper.
Disadvantages of debt
Failure to repay debt can leave the company vulnerable to insolvency. If the company has unpaid debts and its outgoings are greater than its income this can make future borrowing very difficult.
The lender may impose certain obligations on the borrower such as providing regular updates on the business’ performance or limiting what can and cannot be done (for example, a restriction on the company taking on more debt). There may also be a requirement to secure the loan against assets of the business or personally guarantee to repay the loan in the event that the business fails to do so.
Other investors and lenders will be reluctant to invest in or lend to a business which is highly ‘geared’ meaning its debt is a high proportion of the monies held by the company.
Equity financing is typically used by start-up businesses. The reason for this is that unlike high street banks, private investors may be prepared to provide money on the condition they are given shares in the company rather than an obligation to repay it. The investor will hope to make a return by receiving a proportion of the profits of the company and, in the longer term, by reselling the shares they own at a profit.
Advantages of equity
The investor does not have to be repaid and so all the monies received can be spent on expanding the business.
The company’s gearing (meaning the ratio of its equity to debt) is lower and so other potential backers may be more likely to invest or lend money to the company.
The business is started without the burden of debt. Investors take a long-term view and so will not expect an immediate return on their investment.
The investor may provide expertise which will help build the business.
Disadvantages of equity
The investor will take a percentage of the business’ profits which might be much greater than the interest payable on a loan if the business does well.
The investor will be a shareholder and so will be entitled to participate in the decision making process.
An investment deal usually takes more time and, therefore, more money to put in place in comparison with debt finance.
Lenders and investors – what are they looking for?
Lenders and investors have very different objectives because, as explained above, they are looking for a different return on their money.
A lender’s primary concern is the borrower’s ability to repay the loan. They will make a decision to lend based upon whether a business can service the debt for the duration of the loan, in other words, what is the risk of non-payment? This can cause particular difficulties for a new business which typically predicts losses in its infancy.
Equity investors make the bulk of their profit by selling their shares at an inflated price and so will be looking at a new business for potential growth and profitability over a longer period of time. Investors will take higher risks because the rate of return may turn out to be much greater than the return on a loan.
Which form of finance is best?
It depends on the situation and what finance options are available to the borrower. The use of debt and equity isn’t an either/or decision and combining both can balance the downside of the other.
The right ratio will also vary according to the type of business. Factors such as its credit rating, the business plan, the tax planning of the potential investor and the amount of money needed to expand the business are all relevant to reaching an informed and effective decision. As is so often the case in business, there is no one size fits all criteria to adopt.
If you would like to find out more about financing options for a start up business or you have any questions, please contact us.