Highlights- Which Way?

Which Way?

It is impossible to generalize which source of funds is the most appropriate for all businesses and projects. The use of debt, equity or a mix of both really depends on the specific circumstances the company is facing, as well as management’s appreciation of where the business is going. This is true for any type of business along the evolution spectrum.

Krogger Highlights | 2015

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Small business owners, CEOs, CFOs and entrepreneurs invariably ask themselves two related questions when thinking about their financing options: should they raise money from an equity investor or borrow money from the bank? Determining what path is the most appropriate to take when funding projects and businesses has found supporters and critics on both sides alike, which has led to the one and only sensible answer: it depends.

It is impossible to generalize which source of funds is the most appropriate for all businesses and projects. On one hand, it does really depend on the specifics of the situation, the company, its strategy and even personal preferences of the owners and managers. Timing is also important. Sometimes is better to use debt and sometimes is better to sell equity – their relative cost, availability and terms will all dictate what makes more sense for the business at any given point in time.

Still, it is important for companies to understand the advantages and disadvantages of using debt, equity or a mix of both. What follows is a brief description of each source of finance, their key differences and more importantly, what implications managers and owners need to consider when deciding which way to go.

Equity Financing

Equity financing implies having an investor (venture capital firm, angel investor or institutional investor) writing the company a check in exchange for a stake in the business. Their main interest is on generating returns out of their initial investment and therefore will favor opportunities with high growth and profitability potential where they can get a good share of the equity. Their focus is on the upside.

Equity investors make their returns through dividends, which are payments they receive from the company if everything goes well and capital gains, which refer to the profit they make when they resell their shares in the future.

From the point of view of the entrepreneur or business manager, the advantages to equity financing include:

Relatively Less Risk – in contrast with a loan, equity financing is risk money – which means that the company does not need to pay the investment back to the investor if things go wrong. This is why investors demand a significant return via a share of the company – to compensate for the risk of losing their money if things don’t go according to plan. More specifically, professional investors tend to look at risk-adjusted returns, which incorporate an assessment of the risk they get into when investing in a new business. The higher the risk they perceive, the larger the return they will demand from the investee.

Expertise – rarely an investor is only about the money. Most investors bring significant experience, contacts and guidance to the table. Finding the right equity investor is incredibly valuable to start-ups and established businesses – the value they create as partners in the company usually outweighs the money they invested in the first place and lasts for longer

More Cash Available – as the company does not need to pay the investment back to the investor in the short term, more cash is available to the business. This unlocks significant value for both the investor and the entrepreneur as all the cash generated can be reinvested in the company to further its growth and boost the value of its equity.

Access to Further Financing – all things being equal, having equity investors now does not preclude the company from having additional investors in the future if the financing rounds have been properly managed. In fact, having people investing can add credibility to the project or company, attracting thus more investors if additional resources are required.

In contrast with debt financing, where the ‘bandwidth’ of the company to support additional debt is limited, bringing additional investors is almost always possible. And even if initial investors get diluted, the injection of new capital might be justified by the potential value to be created (which benefits all shareholders).

On the other hand, bringing equity investors on-board also has its disadvantages:

It requires giving away (at least to a certain degree) ownership and control in the company – attached to the investments they make and the stake they receive, investors usually require governance rights that dilute the level of control owners and current shareholders have over the company. Specifically for founders, this implies that they no longer will be able to make significant decisions on their own, but will have to consult, and in certain situations seek approval from, the new investors in order to move forward.

In many instances, particularly when start-ups require large amounts of capital to operate, entrepreneurs might have no other option but to significantly dilute their participation and could end up losing control of the companies they founded. The value of their stake, of course, is arguably many multiples of what it could have been if no money had been raised.

It is time and resource-consuming – finding the right equity investor is not an easy task. It requires entrepreneurs and business managers to work hard and dedicate valuable time that otherwise could be directed to build or run the business. And even if they find a potential investor, negotiations could drag on, things could go wrong and all the time, effort and money invested (do not underestimate legal fees) could be wasted if the deal falls apart.

It could be far more expensive than borrowing cash (if things work out) – as mentioned before, the returns demanded by the investor respond to the risks they take by investing in a company or project with an uncertain outcome.

For a cash-starved start-up, an equity investor’s money is life-saving and most likely the only available option. In this context, a sizeable share of the company might not seem demanding at the outset – but if things go well – if the company makes it big time – such share will probably look like a lot, particularly when compared with the founders’ piece.

The dilemma is clear. If things work out, founders might end up giving away too much. But absent the investor, the company and the founders’ valuable share might never have materialized.

Debt Financing

In contrast with raising money from an equity investor, borrowing it from the bank or any other lender, does not require giving away a share of the business. The owners retain full control and ownership of the company. However, the borrowed money has to be repaid (plus interests) in line with certain pre-agreed terms and regardless of how well (or badly) the business performs.

Because the money has to be repaid, lenders’ interest is on ensuring that the company will be able to pay back the loan, on time and in full. Their focus is on the downside and therefore, they favor companies with a steady, solid stream of cash flows.

From the point of view of the entrepreneur or business manager, the advantages to debt financing include:

Ownership and Control – as mentioned before, when borrowing money, the owners and managers retain full control and 100% ownership of the business. They alone make all decisions and are fully responsible for the operation and results of the company. The bank or lender has no say in the way the company is run.

In certain circumstances, it is possible for the lender to include covenants as part of the loan agreement. These are stipulations that set limits on certain activities that the borrower can carry out in order to protect lenders from the possibility of the company defaulting on its obligations. For example, a common covenant includes limits on the amount of additional debt the company can get.

Tax Shield – the interest payments related to the loan are tax deductible. This means that by financing a venture with debt instead of equity, the interest payments on the loan are an expense that reduces the profitability of the company and therefore reduces the amount of tax payable to the government. This benefit is far more tangible to stable companies that are profitable already.

Known Cost – the amount of money the company owes and the corresponding interests are known figures (to a lesser degree when the interest rates are variable). These in general, do not change if the performance of the business changes. If the company does very well, it does not have to pay more than what it owes and everything else is value that goes straight to shareholders.

Easier Process – assuming that the company or business idea is eligible for a loan, the process of getting the money is far simpler than sourcing equity financing. There is no need to ‘due diligence’ the lender, no share and value negotiations and professional fees in general are limited. Once the principal, interests and terms have been agreed, the money hits the bank account and that’s it.

The main disadvantages of borrowing money include:

Higher Operational Risk– since repayments on the loan need to be made regardless of the performance of the business, when things go wrong, the company can struggle to meet its obligations. This is particularly dangerous for new and cyclical businesses, which have low or irregular cash flows. The world is full of examples where unforeseen turns of the market have pushed highly levered companies to bankruptcy after they weren’t able to pay back their loans.

Less Cash to Grow – a loan is a burden and in that sense, companies need to make sure they have enough capital to pay back their debts and at the same time to invest in the business. Many companies live only to service their debts and stop growing.

Limited Additional Funding and Riskier Profile – there is just so much debt that a company can handle. Too much leverage and the business losses all financial flexibility. Debt can easily snowball to unmanageable levels and scare away any other potential sources of financing when most needed. In fact, high levels of debt make the company’s equity riskier – since the probabilities of default increase – and therefore create a highly toxic environment for all parties involved in the business.

Limited Access for Start-Ups – lenders’ focus is on the consistent flow of enough cash to repay the loan and the related interests. A start-up by definition does not generate cash flows in the initial stages of development (most don’t even have revenues) – so borrowing money from a bank seems impossible.

Access to lending facilities for entrepreneurs and small companies tends to require personal guarantees or collateral in the form of assets. If things don’t go as planned, the bank can seize them, indeed transferring the full risk of failure to the entrepreneur or owner.

Mixing Both

After reading the differences between both sources of funds, one might conclude that in general equity investing is better geared towards start-ups and small companies, while debt financing is better suited to established and mature companies. This might feel intellectually comfortable – after all, it sort of makes sense – but the reality is far more nuanced than that. A company cannot decide which source of funds to use without a full understanding of its likely future cash flows and investment requirements. As indicated above, the use of debt, equity or a mix of both will really depend on the specific circumstances the company is facing, as well as management’s appreciation of where the business is going. This is true for any type of business along the evolution spectrum.

For example, an internet start-up with low capital requirements and high margins could easily be a better candidate for a loan than a pharmaceutical multinational developing a new revolutionary drug. It really does depend on the situation.

Having said this, we would venture to suggest that the real question is not which source to tap into, but rather what relative proportion of both is suitable. In many cases a mix of debt and equity is the healthier way to go when financing needs arise. A sensible, tailored combination of both can maximize the amount of money available to entrepreneurs and business managers and at the same time satisfy the needs of investors and meet the obligations imposed by lenders.

 

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