Debt vs Private Equity: Which Is Best For Your Business?
If you need to raise capital for your business the major decision is the choice between debt or equity as the source of funds. While the distinction between these two options is clearly understood, what is less clear is the best way to determine what is most appropriate for your business and situation.
Pre-existing opinions from various stakeholders can skew the process, without correctly determining the relative pros and cons of each alternative.
At a high level, debt is cheaper (interest rate as opposed to a stake in the business) but riskier than equity. The good news for business owners is that there has been a recent increase in lenders (such as non-bank credit funds) and sources of private equity (such as family offices making direct investments).
But one size does not fit all when it comes to raising capital, and every business needs to carefully consider their specific circumstances to work out the best mix of debt and equity. We’ve identified four key factors that will help you weigh up your options.
1. Return
For fast-growing businesses, debt is almost always cheaper, even if interest rates are relatively high. If your company valuation is rising faster than the interest rate, equity is more expensive because you are giving up a percentage of your company by issuing new stock. But, and very importantly, if debt is considered the best alternative, you need to work out how much debt you can safely carry.
2. Risk
Debt must be paid back as a priority over any equity investments. Covenants relating to business performance can be strictly enforced for the duration of the loan and lenders can demand their money back if there are any breaches. A period of poor performance can leave your business in a very vulnerable position, even requiring you to raise more capital to repay some or all of the debt. Worst case, a secured lender can appoint a receiver and take possession of your company and sell it to recover their money.
Forecast cash flow is critical in the return vs risk trade-off. If earnings are uncertain or highly fluctuating (such as a contracting business with low barriers to entry), large levels of debt are unadvisable as even a short-term adverse trading period could see you lose your business entirely. On the other hand, if your business is well-established with long term customer contracts, or operates in a non-discretionary sector with predictable and stable cash flows, then you can safely take on higher debt as it will be far cheaper than giving up equity (assuming forecast capital growth is higher than the interest rate).
3. Control
Debt is generally a passive source of funds. If you meet payment commitments and operate within financial ratios per the loan contract, lenders will generally leave you alone to run the business. Unless you breach any loan terms, lenders will have no control over your business (and they don’t want control anyway).
However, equity investments are rarely passive. It is akin to a partnership, and the level of involvement of an investor will be directly related to the amount of the company they own.
How much control will the equity investor have?
- 10%+ the incoming investor will insist on board representation
- 20%-30%+ the investor will get veto rights on key decisions around investments and acquisitions
- 50%+ they will have total control and can change business strategy, replace management or even sell the company
Control can be a big sticking point for founders when seeking to raise capital, especially if they want to maintain a tight rein on their business. Consider also that an equity partner can bring a lot of non-monetary added value to a company – increased reporting discipline, better financial controls, expertise on expansion and even a path to a company float. Equity investments need to be carefully considered in terms of the percentage holding they will be seeking in return for their investment.
4. Timeframe
Lenders are only around until their money is repaid. In the Australian market, debt tends to have a fixed maturity rate of three years. It is temporary in nature and there are no guarantees the loan facility will be extended, even if the funds are needed beyond the loan contract termination.
Equity is permanent. Once an investor is on-board, there is rarely anything that can compel them to sell. And the converse is true – you are not compelled to return investor funds, unless the shareholder agreement has agreed ‘go to market’ clauses forcing a sale process in an agreed timeframe.
Understanding your desired exit path and the expected liquidity of the business over a period of time will help with the choice between borrowing or seeking an equity investor. Fixed term debt that may need to be refinanced at a point in time when the business may be in worse financial shape is a poor option. Similarly, an equity investor who is not culturally aligned or a good fit for the business will be very difficult to remove once they are on board.
The other side of the equation
What we have highlighted above is a good start as you embark on the process of raising capital for your business. Note though that we have not covered the other side of the equation – the criteria lenders will apply to provide loan funds, and what investors look for when considering equity funding.
Neu Capital has a broad range of mid-market investor relationships across credit funds, private equity and family offices. We have a detailed understanding of the types of investments they have completed and the criteria they use to decide to lend or invest. We are best placed to help you and your business navigate the diverse world of capital providers to help you reach your goals.
