Debt vs Equity: The hidden issues you must consider
It’s not just a question of debt or equity, but a question of control, ownership and reward
“I can’t believe it! The bank has actually said yes! They’ll need my personal guarantee, but because our business is going like a rocket at the moment they’ll do the whole £500,000 we need for working capital. It’s a bit of a no-brainer, but much less hassle than raising equity.”
So enthused a friend when we met up recently. She has got a great business and needs money to grow – and fast.
But is she really sensible, taking on debt to grow? The reality is it’s one of the most underrated forms of funding for a business. If your company’s finances are robust enough you will get everything you need by going into hock: zero interference from financiers; maximum control over the business and a bigger pay-out when you sell up.
Provided, of course, you stick to minimum levels of profitability, keep your bank in the picture with management information when it needs it and you keep acceptable debtor cover.
It’s cheap too. You pay loan interest, at a margin of 1.75% to 2.5% over base rate, while you pay a lending fee of around 1% to 1.5% of the loan.
In fact, when you look at the benefits of funding your growth out of debt it’s hard to see how it stacks up against private equity.
Firstly, venture capital is expensive. You may not have to make capital repayments, but as soon as you take a VC’s money the only thing they will be interested in is payback. The clock is ticking towards that exit and they will want to see an improvement of 30% on the money invested within three-to-five years. This means that for your £500,000 now, you’ll be paying over £1m in a few years’ time.
Then there’s the issue of how you spend the money you raise. Well it won’t actually be down to you. It’s the VC’s money and as your new partner they will want to have more than a little say on how it’s used. They will sit on your board and be in a position to veto and challenge your business decisions. You may get a say in the shareholder agreement when you take their money, but like everything in life, it’s the person who pays the piper that calls the tune.
So on that basis should you be haring off to the bank for a loan next time you need working capital or money to grow your business?
Not before you work out what you need in the long-term and how you are going to pay it back. And this is where the drawbacks of debt balance out against the benefits of private equity.
Debt is great when things work out, but when things get sticky it’s not just your business at risk. Banks don’t take risks when it comes to lending so your personal guarantee, which secures the funding, will put your own personal wealth on the line.
Then there are the repayments. Borrow too much and you will have a permanent drag on your cash flow, borrow over too long a term and you pay out a fortune in interest payments as well.
Think of it like a mortgage. There’s not much point in having a £1m property if your mortgage repayments are so big you can’t pay the gas and electricity bills. So it’s not what you can borrow it’s the risks attached to repaying the amount. And just as important, like a mortgage, the amount you can raise in debt may not be enough capital for you to fulfil your plans.
So of all sudden, raising equity looks attractive. Giving 20% to 30% of your business away now isn’t that bad a deal if you can’t grow any other way. That stake may be worth more in five years time if you meet your budgets, but you’re going to get rich too.
Also you don’t have to repay the capital either, so your cash flow gives you more flexibility. A VC may also be more understanding about hiccups and delays. You can guarantee a bank won’t. So is my friend with her £500,000 of bank debt a smart cookie? I’d say so. Why? Not because she has found a cost-effective form of finance, but because she has worked out raising finance is more about just finding someone to stump up the cash. Rather than being the start it has been part of her business plan, which told her how much of the company she wanted to own herself and what proportion she was prepared to pay for the capital.
And that’s where she’s on to something. You can’t assess your attitude to risk unless you have planned every aspect of your company’s future development in detail.
Time to look at your business plan again? I think so.