By Stephen Welton, CEO, For The Business Growth Fund
Taking a business to the next stage can be daunting. It requires confidence, capability and capital. In recent years, the third of these all-important ingredients was relatively easy and cheap to secure through bank lending. That changed with the financial crisis. Today, many business owners will tell you that the new reality means their growth ambitions have had to be put on hold.
However, there is a strong and available alternative form of finance to plan for the long term: equity. A sound balance sheet needs more than just debt. Equity funding was most commonly used to grow businesses before the world got hooked on the availability of cheap debt. Indeed, at BGF we believe that equity has always been one of the best ways to fund a growing business.
Equity investors are taking a calculated risk on the future success of your company and as such are focused on its growth potential. This ensures that the relationship between management and equity investors is one of partnership. This is particularly true of a minority investor, such as BGF, who will be keen to ensure that the interests of all shareholders are aligned with their own.
Equity investors work hard to further the growth prospects of the company in which they are invested and will generally bring with them a book of contacts, as well as broader financial and operational expertise. All of this will benefit your business.
The different characteristics of debt and equity mean that certain types of company are better suited to each and getting the mix right is crucial. For example, lenders are more interested in protecting themselves from downside risk, they will pay particular attention to the track record of the company to ensure that it is able to repay the loan and interest in the short term. Of course many smaller companies are less likely to be able to find loans as they do not have the necessary track record.
Also, as loans require regular cash payments of interest and principal, companies looking for loans need to have relatively stable cash flows. Very seasonal, lumpy or cyclical cash flows make lenders uncomfortable and will likely reduce the debt capacity of a company.
We are not suggesting that funding has to be equity or debt. And we are not saying that there is anything wrong with debt. But we do believe that that there is everything wrong with too much debt. It constrains businesses and stifles growth. Equity investment, as part of the funding mix, can create a better balance and is an alternative that we would encourage fast growing smaller and medium sized businesses to consider. The question for any growing company should not be ‘how much can I borrow?’ but rather ‘how should I plan for, and fund, future investment?’
Questions & Answers
In accepting equity finance, will I lose control of my business?
Equity investors buy a stake in your company at a fair price - and in our case, this is always minority stake. Our return comes from growth generated in the company and as such our interests are aligned with yours. Our investment is a vote of confidence in your ability to manage your business successfully and gives you a firm foundation to build on.
Is equity finance more expensive than debt?
Debt providers are not able to underwrite all of a company’s cash requirements, leaving a funding gap. They will take a limited level of risk and return and expect security, regular interest and the full repayment of their loan in fixed time period.
However, equity funding, in addition to debt, can allow you to build a bigger, stronger business than would be possible using debt alone.
Equity investors do not require such regular cash payments. They are rewarded with dividends which are generally only taken when there is a surplus of cash over the capital needs of the company; in other words they are rewarded only when the company has been successful.
The different risk profile of a lender versus an investor is reflected in the cost of that capital to business. Getting that balance right drives the lowest overall cost whilst ensuring a sound financial structure.
I have a long and close relationship with my bank so aren't they best placed to help me?
BGF works closely with its own banking shareholders and understands the value they can bring. However there is a clear difference in the interest that lenders and equity investors have. Lenders look first for the repayment of their loan and the payment of the interest on it; an equity investor is more concerned about the company’s growth and longer-term prospects.
To protect themselves from a company failing to repay the loan or interest, lenders will typically put financial covenants in place, meaning that the company cannot deviate substantially from the position it was in at the time the loan was made. Lender will also require security and often personal guarantees. Flexibility can be a key factor in favour of equity.
A further consideration is the length of time the capital is made available to a company. Debt has a fixed maturity, requiring repayment at a specified point in time, usually up to three-four years for smaller companies. As companies cannot guarantee that loans will be refinanced in the current economic environment, they must be comfortable in their ability to repay the loan out of their own cash flows within the specified timeframe. Equity investors do not require such specific repayments and can invest for the longer term with a view to an exit at a point that maximises value for all shareholders and is appropriate to the specific needs of the business.
Overdrafts are also popular with small and medium sized business owners as they are easy to understand and offer immediate access to credit. But ultimately an over-reliance on an overdraft facility can be dangerous, even for a growing company. By definition an overdraft is temporary; the facility can be withdrawn or reduced with hardly any notice. Overdrafts are useful and the right way to fund short-term working capital and every company will want a facility at some time, but they are not, and should not be seen, as the appropriate form of long-term capital.
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