We take a look at debt vs equity finance, weighing up the pros and cons for SMEs, start-ups and scale-ups. Expert advice from the lawyers here at Ignition Law.
There are many ways to fund a growing business – small loans, investment from venture capital firms or business angels, government grants or other financial awards. As a business grows it will often look to different sources of funding at each stage of its growth journey.
With the downturn in the market in 2023, we saw an increase in companies seeking more debt-based finance or convertible / hybrid structures.
Each method has its own pros and cons and it’s important to weigh them up and understand which one is best for your stage in business. Often, the decision regarding which method of financing a business opts for will be driven by how much money the company needs, how quickly it needs it and how much control the existing shareholders are willing to give away at that stage.
Two of the key ways of raising money are to fund through debt finance or fundraise from equity investors.
What is debt finance?
In essence, debt financing involves a company borrowing money that it must later repay. The borrower-company will usually be required to make repayments regardless of how it performs, but the lender will not gain an ownership stake in the business.
The forms of debt finance frequently used by companies include overdrafts, credit cards, loans from friends and family members, bank loans, term loan and revolving credit facilities, bonds, and invoice and receivables financing. A company should always ensure that it works with its advisors to identify the most suitable form of funding for its financing requirements and business.
The pros of debt finance
The biggest advantage of using debt finance versus equity finance is control and ownership. With traditional types of debt financing, you are not giving up any controlling interests in your business meaning you maintain all decision-making powers.
Another big advantage is that once you’ve paid back the debt your liability is over.
Debt finance can also have tax advantages. Interest payments made by the borrower to the lender count as “expenses” and can be offset against the borrower’s profits. They are therefore tax deductible. This may not have a big impact in the early stages of the company but can make a huge difference in net profits as you grow.
The cons of debt finance
The biggest downside to using debt is that it requires repayment no matter how well the business is doing, which can be a burden to a burgeoning start-up. Debt finance may involve lenders taking security from the company and/or its shareholders, and/or personal guarantees from the directors of the company. If you, the borrower default on the terms of the loan, the lender may be able to enforce its security, which could entitle the lender to take possession of and/or sell your assets.
Too much debt can increase your company’s gearing ratio, which can negatively impact future profitability and valuation. This can make it harder to raise finance in the future or prevent it altogether.
What is equity finance?
Equity finance comes in the form of equity fundraising from investors, such as existing shareholders, angel investors, crowdfunding platforms, or venture capital firms. It involves investors subscribing for shares in a company in exchange for an ownership stake. It can sometimes be more appropriate for a business than other sources of finance and can bring in more cash than debt alone but also comes with its own pros and cons.
The pros of equity finance
With equity finance there is no loan to repay which can be a big advantage especially if the company isn’t making any profit. Without the burden of debt repayments or costly interest payments, more money can be channelled into the business to boost its growth. The obligation to pay dividends only arises if profit is made and the company decides to declare a dividend.
In addition, the funds invested by an investor in an equity financing will generally not have to be repaid to that investor. Exceptions to this include when the company carries out a buyback of the shares (note the purchase price may be less than the original investment amount) or the company is wound up. In this case the amount returned to the shareholders will depend on the surplus available to shareholders once the insolvency practitioner has distributed the proceeds in accordance with the insolvency waterfall.
External investors can bring valuable expertise to your business in the form of skills, experience, connections, and resources. Because your investor has a stake in the business, they want your business to deliver value. This motivates them to make important contributions to the company, as they stand to benefit more if the company prospers. They could be the key to your future success.
Valuable equity partners can also make it much easier to secure more attractive debt in future.
The cons of equity finance
With equity finance comes a dilution in ownership and with it, a loss of control, however. This could disrupt the business and dilute founder control. A reduced ownership percentage can also mean that you have to split the profits, and in some cases, investors may be entitled to any positive returns before you get anything.
Raising equity finance can be quite demanding and may take your focus away from the core business activities. It is time consuming and can be costly. Lots of questions will be asked, checks will be made, and budgets scrutinised. The time and effort needed shouldn’t be underestimated.
What is hybrid financing?
Hybrid financing is the financial instrument that has some characteristics of debt and
some characteristics of equity. Simply, it is the financial security that possesses the
characteristics of both the debt and equity.
This can be a useful solution for
companies wishing to raise cash quickly in a difficult market where investors’
appetite for funding is low due to the conditions of the market or a riskier company profile.
How Ignition can help you with debt and equity fundraising
There are clearly advantages and disadvantages of both debt and equity fundraising. One or the other (or something else) may be the most beneficial for your current stage of business.
We can help you understand what is right for you and help you through the whole process of raising finance, including:
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Advising you on the financing options available in the context of your business’ circumstances and needs, and the legal documentation required to implement each option;
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Helping you to prepare credible, realistic financial models for prospective lenders and investors;
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Assisting with lender or investor due diligence;
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Drafting and negotiating the documents required to close an equity funding round (including subscription agreements, advance subscription agreements, Safes, shareholders’ agreements, corporate authorisations etc.); and
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Drafting and negotiating the documents required to secure debt finance, including loan agreements, convertible loan agreements or note documents, revolving credit facility agreements, security documents.
For more information on debt and equity finance please contact Helen Gerrard in our finance team.
