In my introductory column, I will give an overview of the pros and cons of the two types of funding, debt and equity. In future columns, I will look at some aspects of these in more detail.
Whether you choose debt or equity depends mainly on how established your company is, so for some companies, there will not be much of a choice. For example, a start up is likely to be financed by equity capital invested by the founders and by their friends and family because it is too risky for debt.
Once you have got past the start up phase, you might then start looking for bank finance in the form of an overdraft, but a bank will only lend if it has security, which may be by way of a charge over the assets of the borrowing company, or it may seek personal guarantees from you.
The main advantage of debt over equity is that you will not have to give up any control of your company, but debt will only be provided for a certain length of time, and overdrafts can be withdrawn by banks with little or no notice which is likely to have a nasty consequence for your company in the form of possible administration unless you can swiftly find another source of funding.
If your company has no assets to offer as security or if you are unwilling to provide a personal guarantee, you will have to look to more equity financing. If your friends and family are unwilling to invest again, external sources of equity will have to be sought, and this will involve you having your shareholding diluted (but your share of your company’s overall value will remain the same).
The most likely starting point for external equity is business angels who will not only provide money in return for a substantial minority stake, but who can also provide you with advice since many are experienced businessmen or entrepreneurs. You shouldn’t overlook this intangible benefit. I can’t help thinking that shareholders get too hung up on being diluted.
For example, if your company has a pre-money valuation of £1 million and you own 100 per cent of the shares, the value of your shareholding is £1 million. If an angel then invests £250,000 for a 20 per cent stake, the company is now worth £1.25 million, you now own 80 per cent, but 80 per cent of £1.25 million is still £1 million.
As your company grows, its risk profile reduces, and it can move up the equity ladder. If you want to remain private, growth capital can be obtained from a private equity fund. Alternatively, you might want to float on a public market, such as ISDX (formerly PLUS) or AIM.
The main disadvantage of the private equity route is that your company will have one large external shareholder (perhaps owning 20 per cent to 25 per cent of the shares) that will allow you to run the company on a day to day basis, but which will be looking for an exit after three to five years, and you might not. The main advantage is that your company can grow away from the scrutiny of the public markets.
Conversely, a float will mean that several institutional investors will end up owning the same 20% to 25% but this will be split amongst several institutions such that none will own more than perhaps 5 per cent. These institutions will let you get on with running the company and will only step in if things go drastically wrong.
The downside is that your company is in the public eye which is fine until things go wrong. However, as with the business angels, both routes will involve your control being diluted to some extent but, as your company increases in value if things go according to plan, so will the value of your shareholding.
So my advice to owners of SMEs who have the choice is to think carefully about what you are willing to give up In return for funding: an element of control in return for the permanent capital that equity provides or the more short term funding offered by debt.
