Debt vs equity - the inevitable crossroads for expanding business

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Debt vs equity - the inevitable crossroads for expanding business

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The business has grown and the future looks bright but in order to capitalise on that optimistic outlook you need more money. It's a familiar story and making the right choice between debt or equity finance could be the most important business decision you'll ever make.

For some business owners the decision is easy because the idea of sharing the cake is just completely unacceptable. This is often the case when owners have fought hard with limited resources to make their business a success. The idea that someone else would come in at the last minute and share the glory is understandably unappealing.

In addition if the business owner has come from a large organisation or used redundancy money to start the venture the implications of shared control and reporting to others may be just as unpleasant a prospect.

In most cases equity partners will be seeking majority control in your business and that can often be a bitter pill to swallow. But private equity partners can also bring focus, leverage and extensive contacts that can transform your operation faster and more spectacularly than you could ever do yourself. The question remains is it better to own 100% of a business that makes £50,000 profit a year or 49% of a business that makes £500,000 profit a year?

But getting these sums correct is crucial if you are to accurately assess the opportunity. You need to offset how much your business will grow with the additional equity against how much your stake will then be worth. If you get these calculations wrong you may be frustrated to discover that you would have been better off pursuing a less aggressive growth strategy and maintaining 100% control.

Debt funding might sound like a better option in terms of maintaining control but it's not all plain sailing either. The much talked about credit crunch is having an impact on everyone from would-be homeowners to business owners looking to expand. The traditional banking system doesn't take risks so unless your business falls neatly into easily understood boxes then your access to funds via debt finance may be harder than you imagined. Even if you're hitting your financial targets and outstripping your forecasts if you're not operating in a well established sector you will find it hard to get the funding you need to move forward.

If you are successful then of course this debt funding is susceptible to interest rate fluctuations and with uncertainty set to remain the watchword for 2008 that isn't good for peace of mind. Debt finance does of course offer tax advantages, as interest payments are tax-deductible making the real cost less than the apparent cost. Compare that to hefty lawyers' and advisors fees for arranging private equity and debt finance can look more attractive.

The nature of debt finance however means that you will often need to provide personal guarantees to the lender in order to secure the money and they are in many respects quasi-equity anyway. If your business doesn't do well your equity partner may not be happy but those are the risks they take. If your business doesn't do well and your bank has a personal guarantee they won't be happy either but they have the power to do something about that and liquidate some assets to retrieve their investment.

In the past private equity investment looked for an exit point between five and seven years. These days that is more likely to be three - seven years. That means more pressure to operate to a set schedule and less patience to see a return on investment. It also means that when they want out you'll have to have the funds or access to funds to buy them out otherwise you may have to sell the business.

Equity finance does add kudos to your business and ironically can make accessing debt finance even easier. Just as the leverage offered by debt can fast track equity returns it seems venture capital backing can be the key to securing debt. After all if the streetwise team of a venture capital business, especially one with a strong track record is confident enough to invest in your business that confidence is viewed favourably by lenders when seeking debt funding.

Increasingly business owners with ambitious growth plans will need to weigh up their desire for control, their need for additional expertise and connections, the global financial uncertainty and diminished access to cash and structure a deal that combines the two. Whatever you decide it's one of the most important choices you'll make so be sure to get independent advice, drop your ego at the door and source the best deal for you and your business.