As long as businesses have been around, owners have debated the merits of debt and equity finance.
The problem is that often the people doing the debating have a vested interest in one side or another.
Now, bearing in mind that we are a finance company you’d expect us to tell you that debt is the way to go but we aren’t going to do that.
Instead, we are going to try to give you our unbiased view on equity versus debt and give you some things to think about when you are looking to bring funding into your business.
So in this post, we are looking at;
● What is equity funding?
● What is debt funding?
● The advantages of equity
● The disadvantages of equity
● The advantages of debt
● The disadvantages of debt
● Equity Vs Debt; How do you choose?
What is equity funding?
The equity of a company describes its ownership.
In the majority of cases, this is simply the ordinary shares of the company.
So for example, if a company has issued 100 shares and one person owns 60 and another owns 40 then the ownership of the business is split 60%/40%.
A company can issue as many shares as it likes (as long as its memorandum and articles of association allow it) and they can be of different types.
In the vast majority of cases, companies have ordinary shares that rank equally (or pari passu) in terms of control and share of profits and capital.
But companies can issue other shares that have different rights.
● Preference shares – these may have the right to take a profit at a specific rate before other shareholders get their share
● Capital preference shares – these allow the holders to get a share of any sale or liquidation proceeds before other shareholders.
● Voting only shares – these are shares that entitle the holder to vote at meetings and thus exercise control but not to share in any profits or capital of the business
● Profit only shares – conversely, these allow the holders to share in the profits of the company but have no rights in regard to running the business.
Shares can often have a mixture of the attributes shown above and can be sold privately or on recognised markets like the FTSE or Dow Jones.
Companies may decide to use complex share arrangements where they allocate profit only shares to employees to reward them for their work and voting only shares to the company owners so they retain control.
The whole issue of equity and share arrangements can get very creative indeed and so you can only be sure what rights a particular class of share has when you see the shareholders’ agreement.
What is debt funding?
Debt funding is where a business receives an amount of money and agrees to pay this back over a set period of time or when specific conditions are met.
Probably the best-known version of debt would be a mortgage. Where the money is advanced, secured on a property and then the property owner pays this back in small monthly repayments over a long period of time.
In accounting terms, debt falls into two categories; long and short term. But in reality, the dividing line is pretty blurred, to say the least.
Many years ago there would probably only be three basic types of debt; mortgages, overdrafts and term loans but today the business finance sector is booming and there are more loan products than you could ever imagine.
Debt finance could be;
● Long-term mortgages
● Short term overdrafts
● Term loans
● Invoice factoring
● Asset financing (like HP)
● Asset leasing
● Revenue-based financing
● Venture capital finance
● Peer-to-peer lending
● Export finance
● Future asset finance
Whilst many of these may share a category, the advances in alternative funding mean that there are lots of sub-types of debt finance all with their own particular features.
The advantages of equity
When a company first starts up, equity is usually introduced by the founders.
This means that the people that provide the money for the company to operate are equally invested in the outcome. Equity ownership can be a great motivator.
Equity is also very cheap for the founders. They put their money in and the company only pays a return when it makes a profit or when it is sold. So for early-days businesses it means working capital with no repayment schedule.
There’s no interest payable on the shares either. This means that everyone is motivated to make the business a profitable success. No success means no money after all!
Owning part of a business in this way means that people have a real stake in the outcomes which is why employee share ownership schemes are so popular.
And when you want to bring in more cash to the business to fund expansion, selling more equity to outside investors can achieve this, again with no immediate repayment schedule to meet.
There is another important point to make here in that when you bring in external investors they often bring other attributes rather than just a big bag of cash.
Typically angel investors and private equity companies will bring expertise, contacts and resources that can boost your business’s growth and help you drive expansion.
The disadvantages of equity
That all sounds well and good but are there downsides to equity funding?
The first thing to say is that if you are an investor and things go badly then you are likely to lose most or all of your money.
From a company point of view, the more equity you sell to external investors then the more control you are likely to be giving up. Give more than 50% and it is no longer your company.
Dilution of the original founders’ shares means that they will get a smaller share of the profits and of the eventual sale proceeds.
You also need to be aware that if Private Equity (PE) or Venture Capital (VC) companies come knocking, they rarely insist on a share structure that favours the original owners!
Equity funding is also less tax-efficient than debt finance as the dividends are paid from post-tax profits whereas debt interest is tax-deductible.
If you are setting up different classes of shares then you are going to need professional help and corporate lawyers don’t come cheap. As well as costing a lot of money to set up, share sales can take a lot of time to get off the ground.
The advantages of debt
Probably the biggest benefit of debt financing is that it can be really quick to get in place.
If you have an opportunity that you want to exploit and need a quick war chest or you have a temporary cash-flow issue then you can get debt finance in place very quickly indeed.
There are so many types of finance products out there that whatever your situation, you’ll be able to find something to suit you. Whether it is a long term mortgage to buy your own offices or an overdraft for a month to pay the wages, there will be funders out there.
In most cases, debt financing is easy to understand and operate and for most products, the cost of setting up the facility is really low compared to equity sales.
Interest payments are also tax-deductible, meaning that it is an efficient way to bring in money to your business.
Once the debt is paid off then there are no more obligations but an equity partner can often be there for life.
The disadvantages of debt
So taking on debt sounds like a very good method of bringing in cash but is it really?
As you would expect there are some downsides and you really do need to understand these before you sign on the dotted line.
The most obvious is that this isn’t free money. You’ll often have to pay an arrangement fee and of course, there will be fees and interest to be charged on the principal.
It’s also important to appreciate that the worse risk you are, the more your money will cost. A new business with no track record will find it difficult to find finance and when it does will be quoted very high interest rates.
A long-established concern that has cash in the bank and a successful track record will find more lenders willing to make an advance at a decent rate.
It’s the old story of being able to find cash easily when you don’t need it!
If you don’t pay in accordance with the agreement then you could end up losing assets that the debt is secured against or being taken to court, neither of which are ideal for any business.
And whilst setting up a limited company can protect the directors from personal liability if things go wrong, lenders will often require a personal guarantee to be signed meaning that the directors will be on the hook for any outstanding amounts.
Some lenders will also require regular reporting meaning that you will need to keep in constant contact and others will want to connect to your accounting software or will have systems that you need to enter data onto.
Equity Vs Debt; How do you choose?
So which is right for you?
Well, we’d argue that this isn’t really the question.
You see, we feel that actually, a successful business will employ a mix of both debt and equity financing depending upon its particular needs at that point in time.
It’s perfectly sensible to take out a long term mortgage to finance the purchase of commercial property and selling off equity to do this may not be the best way to go.
But if access to funds is difficult because you are a new business and you have a great proposition, then you may find it a simple matter to bring in external equity investors.
It’s also important to remember that equity investors often bring with them skills, experience and contacts that help your business in ways other than just providing cash.
In fact, larger, successful businesses rarely see this as a binary, equity or debt question.
Instead, they employ a mixture of different types of funding streams that relate to the use the money will be put to.
We’re going to give a shameless shout out to our own product here, R&D tax credit financing.
We advance cash based on the value of a company’s future R&D tax credit.
Now naturally if your business isn’t doing R&D work this product won’t be of any use to you. But at a later point in the development of your company, it may be.
So we’d argue that the type of funding you employ and the mix can change over time, depending upon the needs of your business and its stage of development.
In conclusion, our opinion is that the question you need to ask is “What is the ideal funding mix for my business?”.