Equity or debt: what is the most effective way to fund a growing company?May 2014 | Feature
Taking a business to the next stage can be daunting. It requires confidence, capability and capital. In recent years, the third of these all-important ingredients was relatively easy and cheap to secure through bank lending. All that changed with the financial crisis. Today, many business owners will tell you that the new reality means growth ambitions have had to be put on hold.
However, there is a strong alternative form of finance: equity. This form of funding was most commonly used to grow businesses before the world got hooked on the availability of cheap debt. At BGF we believe that equity has always been one of the best ways to fund a growing business. Here we want to answer some of the questions we are most frequently asked by business owners.
In accepting equity finance, will I lose control of my business?
No. Equity investors buy a stake in your company at a fair price - and in our case, this is always minority stake. We gain from growth generated in the company and as such our interests are aligned with yours. Our investment is a vote of confidence in your ability to manage your business successfully.
Is equity finance more expensive than debt?
It is true that equity investors assume more risk than debt providers and, as a result, they expect to be compensated for this higher risk through a better return than a debt provider would demand.
However the form of that return differs between debt and equity. Lenders expect regular interest and the full repayment of their loan in fixed time period. Equity investors by contrast do not require such regular cash payments. They are rewarded with dividends which are generally only taken when there is a surplus of cash over the capital needs of the company; in other words they are rewarded only when the company has been successful.
Is equity investment riskier for the business owner?
No, far from it. In the case of bankruptcy, debt-holders have priority in the order of repayment over and above shareholders. If the value of a company reduces as a result of weak performance, equity value is hit before debt. The more debt a company takes on, the greater the risk of financial distress if it cannot meet the terms of the loan. In the extreme, this could include the lender forgiving some of the debt in exchange for a stake in the company. Moreover, lenders will often take security against the assets of the company.
I have a long and close relationship with my bank so aren't they best placed to help me?
BGF works closely with its own banking shareholders and understands the value they can bring. However there is a clear difference in the interest that lenders and equity investors have. Lenders look first for the repayment of their loan and the payment of the interest on it; an equity investor is more concerned about the company’s growth and longer term prospects. To protect themselves from a company failing to repay the loan or interest, lenders will typically put financial covenants in place, meaning that the company cannot deviate substantially from the position it was in at the time the loan was made. Flexibility can be a key factor in favour of equity.
A further consideration is the length of time the capital is made available to a company. Debt has a fixed maturity, requiring repayment at a specified point in time, usually up to three years for smaller companies. As companies cannot guarantee that loans will be refinanced in the current economic environment, they must be comfortable in their ability to repay the loan out of their own cash flows within the specified timeframe. Equity investors do not require such specific repayments and can invest for the longer term with a view to an exit at a point that maximises value for all shareholders.
The different characteristics of debt and equity described above mean that certain types of company are better suited to each.
For example, as lenders are more interested in protecting themselves from downside risk, they will pay particular attention to the track record of the company to ensure that it is able to repay the loan and interest. As such early stage companies are less likely to be able to find loans as they do not have the necessary track record.
Also, as loans require regular cash payments of interest and principal, companies looking for loans should have relatively stable cash flows. Overly seasonal, lumpy or cyclical cash flows make lenders uncomfortable and will likely reduce the debt capacity of a company.
Equity investors are taking a calculated risk on the future success of your company and as such are focused on its growth potential. This ensures that the relationship between management and equity investors is one of partnership. Equity investors will be keen to ensure that the interests of management are aligned with their own, which often takes the form of incentivising management with a stake in the company.
Equity investors work hard to further the growth prospects of the company in which they are invested and will generally bring with them a book of contacts, as well as broader financial and operational expertise. All of this will benefit your business.