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As a startup owner, managing your long-term financing might not seem like a top priority. However, your long-term financing is crucial to your startup’s ongoing success. Gearing, also called leverage, describes using debt to fund your startup’s long-term financing. This article will explain gearing and its implications for your startup and its key stakeholders.
What is Gearing?
Gearing describes the use of debt as a source of long-term capital. More specifically, gearing usually describes the effects of using debt, which can increase the value of your startup’s shareholders.
However, these increased returns come at the expense of increased risk. This is because a business must service its debt before paying any money to shareholders. Accordingly, if your startup uses too much gearing, it may be unable to repay its debt.
If this happens, your startup’s lenders may take enforcement action against your startup. If your debt obligations exceed your assets, you and the other shareholders stand to lose the total value of your investment.
Gearing and Capital Structures
You should consider gearing in the context of long-term financing. A startup takes its long-term financing and invests it in projects that ideally will generate a sufficient return on investment that is competitive with the broader market.
To illustrate this, we will look at two examples.
Example One
ABC Ltd is a startup that has raised all its financing through equity. Specifically, it has held a single round of equity capital raising two years after its founders started the startup.
The founders injected £500,000 into the company in exchange for 500,000 x £1 ordinary shares. The equity investors injected £1m into the company for 500,000 additional ordinary shares. These ordinary shares are issued at a £1 premium, for a total of £2 per share.
ABC Ltd has no long-term borrowings. Additionally, ABC Ltd had £500,000 of retained earnings, the sum of ABC Ltd’s first two years of trading profits.
ABC Ltd also allotted the additional shares at the point that it had the following capital structure.
| Source of Capital | Amount (£000) | Notes |
| Share Capital Account | 1,000 | 500,000 shares issued to founders, plus 500,000 additional shares issued to first-stage equity investors. |
| Share Premium Account | 500 | UK law requires companies to maintain a share premium account. This accounts for any premium value a share is issued for. In this case, it is £500,000, which reflects the fact that 500,000 ordinary shares issued at £2 per share = £500,000 nominal value + £500,000 premium value. |
| Retained Earnings | 500 | Retained earnings form part of your startup’s equity. |
| Total Equity | 2,000 | |
| Total Long-Term Debt | 0 | |
| Total Capital Structure | 2,000 |
Example Two
123 Ltd also needs £1m in financing. It decides to raise half through equity and half through bank borrowings. A bank offers a £500,000 loan at 10% interest. All other things are equal to ABC Ltd. It has the following capital structure.
| Source of Capital | Amount (£000) | Notes |
| Share Capital Account | 750 | 500,000 shares issued to founders, plus 250,000 additional shares issued to first-stage equity investors. |
| Share Premium Account | 250 | This reflects that 250,000 shares were issued for £2 each. The premium amount is credited here. |
| Retained Earnings | 500 | Retained earnings form part of your startup’s equity. |
| Total Equity | 1,500 | |
| Bank Borrowings | 500 | |
| Total Long-Term Debt | 500 | |
| Total Capital Structure | 2,000 |
ABC Ltd vs 123 Ltd
Both startups’ capital structure is worth £2m. However, 123 Ltd has a gearing of 25%, calculated as:
Long Term Debt/Total Capital Structure = Gearing= 500/2,000 = 0.25 x 100 = 25%.
ABC Ltd has no debt, so its gearing is 0%.
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What Are the Advantages of Gearing?
Startups can use gearing to engineer higher dividend returns for shareholders. This is possible since:
- the government allows companies to deduct interest from their pre-tax profits; and
- using debt means you issue fewer shares, which minimises the diluting effect of issuing further equity.
To illustrate, let us assume the first year after the financing, ABC Ltd and 123 Ltd generated £500,000 in operating profits, or the earnings after sales and operating expenses but before interest and taxation.
We will use the current corporate tax rate of 25%. Both companies will also issue a dividend to shareholders of 5p per share.
| ABC Ltd (£) | 123 Ltd (£) | Notes | |
| Operating Profit | 550,000 | 550,000 | |
| Interest paid | 0 | (50,000) | 10% interest per year on £500,000 borrowings = £50,000 |
| Profit before tax | 550,000 | 500,000 | |
| Tax (25%) | (137,500) | (125,0000) | |
| Net Profits | 412,500 | 375,000 | |
| Number of ordinary shares | 1m | 750,000 | |
| Earnings per share (EPS) | 41.25p | 50p | This is the total amount of earnings available to shareholders (net profits) divided by the number of ordinary shares. |
Unpacking the Effect of Gearing
Earnings per share (EPS) is an essential financial metric investors use to assess the quality of an investment opportunity for equity investors. It takes the total earnings available to shareholders (net profits) and divides this figure by the total number of outstanding shares.
Notably, earnings per share does not look at the amount of dividends paid. It looks at how much a company could feasibly pay shareholders out of its available earnings. This is because any earnings not paid out to shareholders via dividends become part of the company’s retained earnings, which enlarges the company’s equity value.
As you can see, 123 Ltd has a higher EPS. This demonstrates how companies with capital structures of the same value can use gearing to increase shareholder value.
What Are the Disadvantages of Gearing?
Gearing can be appealing when looking at EPSs, considering it almost looks as if the company has created more value available to shareholders. In some respects, this is true, mainly because of the tax advantages available to startups that use interest-bearing long-term borrowings to finance their capital structures.
However, gearing increases the risk that your startup cannot service its debt. Therefore, another way to view the increased EPS for a geared company is the risk premium shareholders demand to compensate them because the startup’s lenders have the first right of repayment ahead of equity investors.
Practical Considerations
When considering gearing for startups, you should consider how:
- startups may find it challenging to borrow considerable sums of traditional debt;
- a common source of borrowing for startups is convertible debt, which allows lenders to convert their debt to equity rather than obligate the startup to repay the amount borrowed, therefore diluting the effect of gearing; and
- it is harder to value private companies than publicly traded companies, meaning valuations used to calculate investor metrics may not be accurate.
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Key Takeaways
Gearing describes the use of debt in your startup’s capital structure. The shareholders in highly geared startups may enjoy higher dividend returns and capital growth due to the tax advantages and anti-dilutive effects of using debt as part of the startup’s long-term financing. However, this comes with the increased risk that the startup will be unable to service its debt in the future. There are also practical considerations. Namely, many startups cannot easily access debt financing, which makes any potential advantages to gearing irrelevant.
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