Debt or equity: which is best to support the growth of your business?

Established businesses by their very nature tend to have an asset base that they can leverage to support secured lending when finance is required. This is reflected in profit and loss (P&L) reserves that have been retained and invested by the business over many years in a range of assets including property, plant and machinery, debtors and stock. However, if an established business has a low level of gearing it does not necessarily mean that equity doesn’t have a part to play.

Jamie Fraser of MavenThere are several factors that influence whether debt, equity or a combination of both is the right fit for an established business. Jamie Fraser, Investment Manager based in Maven’s Newcastle office, sets out his thoughts on how to identify the most appropriate funding package for your business and highlights when equity could be part of the solution.  

Understand your stage in the business cycle

The stage of development or the scale potential of your business will largely determine whether debt, equity, or a hybrid of the two is more appropriate. Usually, as businesses mature, they become profitable, build cash reserves and invest in assets. This is especially the case for asset intensive businesses in sectors such as manufacturing and leisure. Often such companies have an asset base to provide as security in support of traditional forms of funding. However, what happens when there is a generational or transformational change opportunity? Is traditional secured lending still the answer?  

Transformational growth

Transformational moments can occur at any stage during the life cycle of a business, and when they do, traditional secured lending may not be the best option to capitalise on a potential growth opportunity. This could include a major site move or the launch of a new product or service where the upfront costs are substantial. In such circumstances the resulting profit and cash generation from the expanded business is less clear than from existing operations.

Whilst secured lending could still be the answer when there is an underlying asset base to fund, cash generation may not be enough to service the additional debt during the early stages of the new investment, even if everything goes smoothly. If things don’t go exactly to plan this could result in cash and relationship pressures with the secured lender. In such cases equity could be the answer, rather than declining the opportunity or reducing the investment amount and potentially limiting the growth opportunity.

Ownership change

Like transformational growth there will be moments in the life cycle of a business when ownership changes could also lead to an equity requirement. These conditions often occur when a founder looks to reduce their day to day involvement in the business or to exit completely, or to ‘cash in some chips’ and take a sizeable amount of cash off the table. Although in some cases it is possible to fund this via traditional debt finance if the company’s balance sheet and the deal structure permits, it is more likely to require some form of equity or a hybrid of the two. In instances such as MBOs, equity can play a key role even when the transaction could be funded via traditional sources of funding.

When the decision to sell some equity is taken, the motivation is often more than purely financial. An equity investor can provide added value by offering strategic and operational guidance to management to support the growth plans. They will also often look to support the business with a Chairman or Non-executive with a skill set and network to complement the existing team. These will generally be experienced individuals who have previously grown and exited businesses, and who appreciate the challenges faced by the CEO of an SME, so can provide coaching and valuable insight to what can be a lonely role as a CEO. Furthermore, equity investors are well placed to utilise their network of contacts and significant experience of working with other companies to support a business as it grows.

So, which is the best finance option for your business? Speak to Maven’s local team about your current and future needs, and our experienced investment professionals will be able to guide you on your funding requirements. Contact our team today on 0191 731 8590.

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