Raising capital: debt vs. equity

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By Dominic Buch, co-founder and managing partner, the growth credit specialists Caple

How best to raise capital can be one of the most difficult decisions that many small and medium-sized business owners face. With the rise of alternative financing, owner-managers can now choose from a plethora of options.

However, quite often, the basic choice still comes down to one of two alternatives: equity financing or debt funding.

Put simply, equity financing is where business owners obtain capital in return for a share in their company. The funds might come from venture capital, private equity or peer-to-peer or crowd funders.

Debt funding involves securing a loan which is repaid over time, with added interest payments. This funding might be supplied by a bank, a specialist debt fund, or an alternative provider.

So, how does equity financing stack up?

The key benefit is that the investor assumes the risk. If the company fails, the business owner does not have to pay back an equity investor.

Third-party investment doesn’t suit every sector, business or owner manager, however. It also dilutes ownership immediately and over the longer term it dilutes the reward if the firm is sold.

Our research of 300 SME business owners shows they do not want to issue equity in their business to fund growth. Indeed, more than half (53%) would be unlikely to do so, sometimes even if it was their only choice.

When looking at the reasons why, it’s clear that business owners feel they don’t need someone else telling them what to do, which is often a result of equity finance.

Paul Starkey, founder and managing director of the UK’s leading manufacturer of orthopaedic braces, Neo G, a firm Caple has supported, puts it succinctly: “We know what we need to do, we just needed the funding to do it.”

Debt funding, especially from traditional banks and specialist debt funds, often requires security – or a physical asset against which the loan is secured.

However, getting such secured funding can often be a problem for slightly larger, more sophisticated SMEs and owner-managed businesses, which may not have the assets to use as security.

This is because while banks can provide funding that reflects the value of the assets in a business, they can’t help if a business has no further assets to borrow against.

Where a physical asset isn’t available, banks or funds may ask the business owner to agree to a personal guarantee. These personal guarantees can be as high as 20 to 30 per cent of the loan value.

If a business is borrowing £1 million or more you can understand why a director might not want the personal risk.

As a result, growing firms must often consider the difficult choice of scaling back their growth, diluting their ownership or agreeing to onerous personal guarantees.

However, asset-light businesses can now benefit from unsecured lending, which is based on an understanding of the future cash flows generated by the business.

Such “cash flow” lending meets the finance firms need to grow while removing both the need for security and a personal guarantee. Crucially, it also means business owners do not need to give up ownership or control.

Given SMEs are are such an important part of the UK economy, we must help them access the finance they need to grow. Now they can do this without being pushed towards diluting equity or losing control.