Should Your Business Choose Equity or Debt Financing?

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Learn how to choose the right capital structure, navigate current debt and equity financing trends, and make informed decisions to fuel your company’s growth in today’s high-rate environment.

Should Your Business Choose Equity or Debt Financing? A Guide for Entrepreneurs

From tech innovators in London’s Silicon Roundabout to biotech pioneers in Cambridge, companies across the UK are leveraging both equity and debt to fuel their growth. But which path is right for your business?

This guide looks at equity versus debt financing, offering crucial insights for entrepreneurs navigating the complex world of capital raising in today’s high-rate environment.

Understanding capital structure: equity vs. debt

Simply put, equity financing involves raising capital by issuing ownership shares in the company.

Many mistakenly believe equity financing is only available to major corporations gearing up for IPOs.

However, the British Business Bank’s recently released Small Business Equity Tracker paints a very different picture: in Q1 2024, small businesses secured £2.3bn in equity funding, up 7% from Q1 2023 and matching the 2018-2020 quarterly average.

Equity finance options include:

  • Private equity.
  • Venture capital.
  • Angel investors.
  • IPOs.
  • Mezzanine finance.

Typical candidates for equity finance include early-stage but high-growth companies. This is because early-stage companies often lack the collateral or cash flow history needed for traditional debt financing, and investors are drawn to the possibility of substantial returns if the company succeeds and scales rapidly.

Equity investors typically gravitate towards high-growth sectors like tech, prized for scalability, and healthcare, driven by aging demographics and medical innovation demand. Indeed, biotech seed funding surged by 190% from 2020 to 2023, with biotech startups securing 16% of all capital raised in 2023.

On the other side of the coin, sourcing equity funding in the consumer sector has been more challenging in recent times. On Carta’s platform, consumer companies raised just 7% of all seed capital, the sector’s lowest market share dating back to at least 2018.

Debt financing involves borrowing money that must be repaid with interest. It is generally better suited to established businesses with good credit, strong trading history and collateral, and to those whose projected returns exceed total interest.

Debt finance options include:

  • Term loans.
  • Business lines of credit.
  • Invoice factoring.
  • Business credit cards.
  • Peer-to-peer (P2P) lending services.
  • Commercial mortgages.

Debt financing has its own set of advantages. Firstly, tax deductibility of interest payments often lowers the effective cost of debt financing, while consistently repaying debt can strengthen a business’s credit profile, potentially leading to more favourable terms for future financing needs. And unlike equity financing, debt financing allows business owners to retain full ownership of their company, maximising earnings in the long run.

Recent trends in the debt financing space include an uptick in covenant waivers and resets, interest payment holidays and other similar portfolio management activities. Meanwhile, highly-leveraged structures have faced heightened pressure from rising interest rates.

Despite a 2023 dip in private debt fundraising, riskier debt products such as mezzanine and growth debt have also gained traction.

Other trends include the increasing prevalence of PIK toggle features (which allow a borrower to compound some of the interest accruing on loans and add it to the principal outstanding), and an increasing use of interest cover covenants.

Should you raise equity or debt for your financing needs?

All else being equal, companies will aim for the most cost-effective financing solution, and debt tends to be cheaper than equity for two main reasons:

  • Tax deductibility: Interest paid on debt is typically tax-deductible, reducing the overall cost.
  • Lower expected returns: Lenders usually expect lower returns compared to equity investors or shareholders.

Moreover, debt doesn’t dilute ownership, even if it comes with covenants restricting certain actions.

Despite its cost advantages, debt comes with limitations.

Companies often face restrictions on how much debt they can take on relative to their earnings. This may take the form of a net debt-to-EBITDA ratio or a EBITDA-to-interest coverage ratio. The lower the net debt-to-EBITDA ratio, the higher the probability of the firm successfully paying and refinancing its debt.

Indeed, to reflect a riskier environment, the use of these interest cover covenants increased from an average of 6% in 2021/22 to 19% in 2023.

It’s crucial to model various financial scenarios to see whether the company can meet the required credit stats and ratios, even in extreme downside cases that assume low revenue growth and margins.

If stress tests reveal potential issues, companies should consider alternative debt structures, such as those with higher interest rates but no principal repayments. This includes mezzanine financing, second lien subordinated notes, or PIK notes. 

Or, for those seeking infrastructure or project finance, interest and principal repayments could be varied over time, being ramped up as the project nears completion.

If debt options still prove unfeasible, equity financing might be the answer. This could involve using equity for some or all of the company’s financing needs.

In summary, when evaluating financing options, pay close attention to:

  • Debt-service coverage ratio (DSCR): This metric helps assess a company’s ability to meet its debt obligations.
  • Debt serviceability on downside and extreme downside cases: If debt looks unserviceable on downside and extreme downside cases, adding in subordinated debt or equity may help to reach the DSCR ratio.
  • Qualitative factors: Besides financials, qualitative factors should also help you to assess debt serviceability – for example, industry health, EBITDA margins, monopolisation within the market, etc.

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