Best way to finance a company: debt or equity

How can I fund my business?

Broadly, there are two main sources of funds for your business. In reality, there are multiple sources including examples such as the businesses own cash and the businesses owners cash. However, for the purposes of this article we will focus on external debt e.g. from a bank, and external investment (or equity) from other investors willing to buy a portion/ share of the business.

Why would you fund a business with debt?

Often, personal finance blogs will strongly advocate to avoid debt at all costs. This advice is specific to individuals. To businesses, debt can be a very useful tool for expansion.

The business ability to take on debt depends on its ability to service that debt. The business needs to assess the returns from potential debt funded projects. If the proposed average rate of return (yield) from the project is higher than  the cost of the debt then the project should be funded.

The benefit of debt is leverage. Debt allows a business to expand, growing cash flows whilst using other peoples' money and not having to dilute the ownership of the company. Why use your own money when you can use someone else's?

Take for example a project that will cost £1,000 but produce £500 positive cash flow over four years. This project would produce an average return of 25% per annum if funded from the business's own cash. Alternatively, the business could fund this project by taking a loan from a bank.

Let's say that the debt is organised in such a way that the cost to service the debt each month is £400. This means that the project generates £100 additional cash each month without having to use any of the business's own cash at all. This is leverage in action. Value has been added to the business without the need to invest any of its own cash.

Why does anyone bother with investors?

The benefits of debt are clear. Yet, often business owners/ managers shirk debt in favour of outside investment to fund business expansion.

Debt can be expensive. The bank factors in risk when assessing a loan application. The bank needs to be sure that it can get its money back. They do this via expensive interest charges.

Furthermore, the bank will take ownership over the bank funded asset or business should the business fail to service the debt. This is called securitisation. The bank is making its position more secure by requesting entitlement of the asset or business should anything go wrong.

The result of all of the above is that dealing with an investor may be preferable to dealing with a bank.

Why should I take on new investors?

The main alternative funding solution to a bank is to negotiate external investment. This could be in the form of money from a friend, silent business partner, private equity, business angel, or anyone who wants a share of the business in exchange for a tranche of funding.

The benefit of external investment is that you don't have to commit to expensive interest charges. Instead, investors may require a share of the profits in the form of dividends. However, there is no commitment for a business to pay dividends unless it wants to. Additionally, there is no requirement to pay dividends unless the business is making profit.

The lack of legal requirement to make payments to an external investor certainly reduces the pressure on the business own. Whereas the interest and bank debt capital repayments can have a detrimental effect on a business's ability to grow.

However, all is not rosy with equity investors. There may be some drawbacks to adding other people onto the list of shareholders.

The first and obvious drawback is the fact that you would need to give up some of the profits of the business. Whereas with a bank loan, all profits after the servicing of the bank loan and after tax belong to the business owner. For someone wishing to receive all the earnings of a business, giving up share capital will be an absolute no no!

Taking on additional investors, not only dilutes the share of profits that the original business owner is entitled to, but also dilutes the control of that business. Business decisions may need to be agreed upon by other shareholders. Not so with a bank (in broad terms).

How should I fund my business?

This all depends on your attitude to risk and your propensity to give up ownership and a share of the profits that the business produces. If you are risk averse then avoiding debt and going for the equity would be a good option. However, if you're the type of person who cannot give up control of your business at all and you're more risk loving then go for the equity.