Should I Raise Finance Through Debt or Equity?

Are you a business owner looking to grow your company? Perhaps you have a compelling idea and have taken the first steps to implement it, but need money to scale? You probably know there are two ways your business can acquire capital (i.e., money): debt and equity. You also know how these operate. Equity investors give your company money in exchange for acquiring shares of ownership, while debt financiers are typically banks that lend your company money in exchange for repaying the loan plus interest. This article explains key legal and commercial considerations you should evaluate when deciding between debt or equity financing.

Overview

The critical distinction between equity and debt financing is that an equity investment dilutes your share of ownership in the company. In contrast, a debt investor will charge you interest for the privilege of lending your company money. 

Likewise, debt financing requires that your business pay an additional amount of money (interest) in addition to the amount you have borrowed. 

We will explore the advantages and disadvantages of each in more detail. 

Cost of Capital

Each kind of financing has its own cost of capital. 

Equity

For equity, your company’s shareholders will be entitled to receive a share of your company’s profits based on the number and type of shares they own. 

At the same time, because you are only paying your equity investors out of your company’s profits, this may be cheaper than debt financing. 

Debt 

For most small and medium-sized businesses, debt financing is almost always conditional on paying interest on top of the amount borrowed. For a debt investor, such as a bank lender, the riskier they perceive the investment, the more interest they charge.

Therefore, this often means that debt financing is more expensive than equity in practice. 

Investor Expertise 

As a condition of an equity investment, your investor may acquire a seat on the board of directors. While this can limit your control in the company, they will have a vested interest in your company’s success. In addition, this means they will ensure your business has access to their expertise and network. 

Cash Flow 

In the context of financing, cash flow refers to the obligations to make outgoing payments to your investors. 

Equity financing gives you more freedom to control your company’s cash flow because dividend payments are at the discretion of the company directors. You may decide that you should not pay a dividend in the first year following an equity investment and instead reinvest the money. 

Loan Covenants 

Loan covenants are legal promises you make to your lender not to do certain things. You may promise to not borrow more money or enter into any other security agreements. If you breach these covenants, this may be an event of default that permits the bank to order your company to repay the total amount of the loan. 

Equity financing does not contain any covenants (though there may be shareholder agreements with similar effects). 

Deleveraging the Capital Structure 

If your business already has lots of debt, you may not be able to take on any more loans. Therefore, equity financing may be your only option if you need to raise money. If you successfully raise equity in your company, it will be more valuable, which will mean that the ratio between your debt and value will decrease. This is called deleveraging.

Tax Benefits 

You do not have to pay tax on the money you have paid towards interest. However, if you declare a dividend, this will be paid out of your company’s profits, which is taxed at the corporate tax rate (19%).

This means that you can offset the cost of borrowing from your taxes, which your company may find advantageous. 

“Juicing” Returns

Depending on how you apply the money raised through a debt financing, you can increase the rate of return on the investment than if you had just used the company’s own cash (such as what was raised by an equity financing). 

This is why most companies usually always have some amount of outstanding debt: it is an effective way to grow your business. 

Key Takeaways 

You can raise money for your company through debt and equity. In practice, there are advantages and disadvantages to both. Firstly, you may not have access to equity investors until you implement your business plan. Therefore, you may need to borrow money from a bank first. However, later on, the cost of capital for equity financing may be cheaper than for debt. Furthermore, you will not have to abide by loan covenants or tightly manage your company’s cash flows under equity financing as you would for a loan financing. Generally, businesses use both equity and debt financings to maximise their financial position. 

If you need help drafting heads of terms for the sale of your business, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today at 0808 196 8584 or visit our membership page.

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