Introduction

If you borrow money which you repay over time, this is commonly known as taking on ”debt’. Alternatively if you raise funds from investors, they will provide the cash you need in return for shares in your business, this is often referred to as an ”equity” investment.

In brief

• Debt and equity – what are they?

• Lenders and investors – what are they looking for?

• Debt – pros and cons

• Equity – pros and cons

• Mixing debt and equity

• What to do next

Debt and equity – what are they?

Any individual or institution that puts money into a business will expect a return on that money. A bank – or indeed any lender – achieves this by charging interest on the term loan or overdraft. The original amount (known as “the principle”), plus the interest charge must be repaid within an agreed time-frame, regardless of how well or badly the business is performing.

The approach of equity investors is fundamentally different. When an equity investment is made, there is no requirement to repay the cash. Instead, the investor makes a return through dividends (payable when the business performs well) and in the longer term by reselling the shares they own at a profit.

Debt vs. equity isn’t necessarily an either/or decision, as many businesses raise cash through a combination of both.

Lenders and investors – what are they looking for?

Lenders and investors have very different perspectives. When you approach a bank for a term loan or overdraft, the bank’s primary concern is your ability to repay both the principle and the interest. They will look at your business plan, assess the risk and make a decision on that basis. Banks will look closely at your sales, profit and cashflow projections to assure themselves that your company is in a strong position to meet its obligations.

Professional investors will also scrutinise your business plan, but in most cases what they’re looking for is the potential for growth and profitability. As they make the bulk of their profit by selling their share at some future date, they want to see the value of their equity stake grow. So, if an investor buys 30% of your company for £25,000 in 2009 with a view to selling in 2012, they are looking growth that will boost the value of their stake to £40,000, £50,000 or £60,000.

There are exceptions. Professional investors including ”business angels” (wealthy people who privately fund early stage companies) and venture capitalists (usually institutions investing in a range of businesses every year) are generally growth focused. Friends and family investors are often less demanding and in search of a more modest return.

Nevertheless, the fact remains that investors have their own, often very strict, criteria about what represents an investible opportunity. Banks and other lenders are more concerned with a solid, credible and sustainable business plan.

Your business plan should include projections of sales, profits and cashflow along with an account of your company’s objectives. You also need to include an assessment of costs, financial requirements and an analysis of the market in terms of revenue potential and competitor activity. It’s important that the figures you use are: a) credible and b) indicate that you will be able to make the necessary loan repayments.

Debt – pros and cons

PROS

• A major advantage of debt finance is that you do not have to surrender shares in your company in return for cash. If you have 100% ownership, that’s how it stays

• Your debt repayments are not linked to performance. So if your profits exceed all forecasts, you pay nothing more to the bank than the return of the principle sum and the agreed interest charge

• Bank loans are more straightforward to set up than equity finance deals and do not incur the same legal costs

• Debts are tax deductible.

“Lenders and investors have very different perspectives”

CONS

• Remember that borrowing cash imposes an ongoing burden on your business. The bank will require regular repayments, even if sales and profits turn down. You should look at your worst-case sales and cashflow scenarios, before taking out a loan

• The terms and conditions (“covenants”) of the loan may impose certain obligations on you, ranging from a commitment to send the debt managers information every month, through to requirements to hit certain performance targets

• You may be required to personally guarantee at least a part of the loan

• You may be required to put up assets as security

• Too much debt can become an unsustainable burden and may frighten away other backers, notably investors.

Equity – pros and cons

PROS

• Equity is risk money. From your perspective this means there is no cash to be repaid should the business perform badly or fail

• Equity investors can often provide valuable expertise, which will help build your business. They can also provide many useful business contacts

• Equity investment can be used to fund the business from start-up through to maturity, with new investors coming in and older ones selling out.

CONS

• Equity investors will only consider companies that are likely to grow rapidly and provide them with a return

• Investors often drive a hard bargain in terms of the stake they demand in return for cash

• Shareholders will want to rubber stamp your decisions. Some owners find this level of scrutiny hard to cope with

• Equity investment can be hard to find. Striking a deal can be time-consuming and distract from the running of your business

• Any equity investment deal will incur legal costs.

Mixing debt and equity

Established businesses often use a combination of debt and equity finance. For instance, it may make sense to borrow money to cover the cost of buying new equipment, but finance for ambitious growth plans may come from a venture capital company. By combining debt and equity you can maximise available funds whilst tailoring both your debt repayments and your obligations to shareholders to suit your requirements.

It can be a difficult balance to get right, so it’s sound practice to speak to your advisors and your bank about the available options.