Incur Debt or Issue Equity?

15 May 2017

When sourcing a capital mix for business growth, there is generally a choice between incurring debt — a risk mitigating performance contract, and issuing equity — a profit sharing partnership.

Debt

In debt, a business agrees to borrow money today and in the future, provide a risk-adjusted return of capital that is usually administered by an ‘arm’s length’ degree of separation to the operations of a business.

Application & Terms

Offering commercial loan terms under a Credit Contract is often straightforward when compared to the complications of securities regulation for issuing equity.  Furthermore, credit risk is priced competitively across a variety of institutional and private channels with funding often delivered to the business under straight-forward and timely terms.

Credit Assessment

Although debt finance is benchmark priced well below equity, for such ‘investment grade’ loan terms, consistent cash flow for the repayment of principal and interest is certainly required. For instances whereby the borrower’s character, capital structure, cash-flow capacity, caveat conditions and/or collateral are graded as ‘non-conforming’, the assumption of debt being cheaper than equity should not be taken for granted.

Security

For securitised loans, a Company will be required to pledge assets to the lender as collateral, and owners of the company may be required to personally guarantee repayment of the loan. This may be a willing compromise to reduce interest rate costs, particularly if the borrower is highly protective and confident to the value of the owners’ equity. Hereby, certain distressed contingencies in operating hardships and possible insolvency events should still be considered and the effect of the senior ranking position of debt over equity will have on business and personal principal.

Tax Effective

Except in the case of variable interest rate loans, debtor obligations are pre-determined and can be budget forecasted. Furthermore, in most GAAP jurisdictions, interest on commercial debt can be deducted on the company’s tax return, lowering the actual cost of borrowings.

Streamlined Stakeholders

Furthermore when incurring debt over issuing equity, the Company does not have to commit to intimate performance reporting that an equity holder may demand nor hold periodic shareholder meetings to seek confidence votes for particular undertakings.

Equity

In equity, a business agrees to the involvement of a shareholder who may at times only desire a passive relationship to profit-sharing, or may also involve active investors, who may attach strategic profit-sharing conditions by Directorship appointment (proxy or direct) and/or preferred rights.

Upside Exposure

The critical point of difference when comparing the sourcing of equity to debt, is that an equity investor takes all of the risk for longer-term performance. In that, a dividend or return of equity capital is only delivered by business performance but conversely the lack of security in a possible failed venture is priced by Enterprise Value adjustments by the investor benchmarking Cost of Equity to Internal Rate of Return.

Strategic Alignment

Although, there can be material downside when sourcing equity by forgoing company ownership, this may not be viewed as a short-coming but rather an advantage particularly if the Offer attracts a leading strategic investor.

By having such an active investor as a leader aligned by equity, the Company will have heightened access to sector expertise, wider industry connections and a committed team partnership for long-term progress. Whilst equity partners may require Executive to maintain regular reporting touch-points to future directions of a venture, this active focus often results in business out-performance.

Exit Terms

Although lack of security provided to equity investors, they certainly will want to know how they are getting their money back. Clear, realistic strategies need to be outlined by Management to the Investment Exit timeline and mechanics of capital structure whether that be through a public or private offer, trade sale, management buy-back, dividends, venture capital or other recapitalisation strategies.

Working Capital & Financial Ratios

Also key when assessing equity in the capital mix, a Company will have more improved working capital under an Equity offer when compared to a same injected capital amount as facilitated by debt. There are no loan payments (both principal and interest) in equity and thus strengthening various performance financial ratios.

Having a stronger equity weighting over debt can be a preferred situation particularly when cash flow is prized or when historical track-record is doubting. Many investors whether funding equity or debt, will scrutinise financial or leverage ratios such as interest cover, to determine if they will provide capital or debt facilities with contingencies also mapped for possible future calls of additional capital.

Decision Framework to Optimise Capital Mix

Ask the following when assessing the future of business needs and corresponding stakeholder dynamics.

  • How predictable is the cash flow of the operation?
  • What are the growth ambitions of the Director/s?
  • How will the additional working capital be utilized?
  • Where is the current operating cycle of the business?
  • How much risk or volatility can the business tolerate?
  • Would the Directors and Managers value a partner in the business?
Debt Equity
Requirements Profitability and often secured by collateral. High growth potential and sustainable.
Effort Choice of timely funding channels. Roadshowing and varied timings to settlement.
Ownership Ownership Maintained Shareholder Dilution
Rates Interest rates may be high + periodic payments. High required returns of capital + exit timeline.
Predictability Set payment schedule. Unpredictable liquidity events & return of capital.
Oversight Minimal oversight. Performance reporting to investors and strategic investor alignment.
Cash Flow Payments deplete cash flow and working capital. No payments means investing cash straight into business.
Covenants Lender may prevent certain actions or operating activities. Versatile to short-term performance but accountable to confidence votes.

Please be in touch if you would like an independent, confidential assessment of optimal equity and debt composition to best suit your venture, operation or investment mandate.

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