The second of three articles by Murray Fulton on Funding for Growth, one of the topics for which he is best known. In this one, he looks at debt funding as opposed to equity funding to help you form an opinion on which might be best for your business.

 

What is debt funding?

There are three common characteristics of debt funding:

  • It usually has a relatively low-interest rate. Bank interest rates are currently at historically low levels, right across the yield curve.  By this, I mean from call interest rates to fixed interest rates (1-year rates, through to 5-year, and 10-year rates).
  • The rate of interest a bank will charge relates to the risk at which the bank assesses your business, the security you offer the bank, and the length of your relationship with the bank.
  • The business can leverage the debt funding and use it to build net cash flow, free cash flow, and its value.

Bank debt funding can be extremely effective and can transform your ability to grow your business and business value. The following example demonstrates this.

Debt funding example

A client of mine had an annual revenue of $3 million and generated an annual profit after tax of $250,000. The equity of this business was $500,000 at the time of this example. An after-tax profit of $250,000 represented a 50% return on the $500,000 equity of this business ($250,000 divided by $500,000 = 50%).

By engaging with a 1st tier bank, with my assistance, the company was able to access bank debt funding at an after-tax rate of 5%, use the funding to generate further growth and continue to generate a return on equity of 40-50%. The business leveraged the use of the bank’s cash to grow. This is good business.

The funder’s agenda

I am often asked to provide clarity on the bank’s agenda.

The agenda of any 1st or 2nd tier bank is simple and does not change. To generate margin by charging interest, and minimise any losses made by having to write-off loans to businesses that cannot meet their borrowing obligations.

It’s important to note that the bank has no interest in (and will not request) equity in your business at any time, unless you fail to comply with the terms of your lending agreement.

Banks only ever look to take an equity position within a business as an absolute last resort to get their money back.  They are set up to work with customers based on debt lending and the management of that debt. They are simply not well equipped to manage equity positions.

Let’s take a look at how banks work:

First, they assess the risk of lending to your business. If the risk of lending is reasonable in the eyes of the bank, then it will lend to your business, on mutually agreed terms.

Next, the bank will request security over assets, to protect its lending position. When a bank is lending to a business that it deems to be at the riskier end of its assessment scale, then greater security is requested.

The least security any bank can request is a General Security Agreement (GSA). This type of lending is provided to businesses that a bank assesses as low risk (often referred to as a “cashflow lend”). The greatest security a bank can request is a combination of personal guarantee, GSA, and real property.

  • A GSA provides a bank with security over the assets of a business.
  • A personal guarantee is a legal undertaking where the borrower is personally liable to repay the debt.
  • Security over real property (land, house and land, commercial, rural, or industrial property) involves the bank taking a 1st ranking mortgage over the real property, to protect its interests.

Security is an important and often emotive issue for a business. I have taken clients from the highest level of bank security to the lowest level. This done by:

  • Demonstrating business performance, which usually means that actual performance is as favourable as the IFF provided. The business needs to show it is doing what it said it would.
  • Building-up mutual trust between the business and the bank, so the bank becomes more comfortable about the operations of the business, the owner(s) and how they manage cash flow.

Finally, assuming you comply with the terms of the bank lending, then it is likely that the bank will be willing to lend you further funds.

 

What is equity funding?

Equity funding has two common characteristics:

  • It usually focuses on the growth of business value, rather the payment of interest on equity and dividends.
  • There is a time-based focus on succession and a “liquidity event”. Realising cash for the whole business, or a portion of the business is referred to as a liquidity event.

Equity funding examples

A business undergoing a succession process, involving a change in ownership. Or the sale of the shares owned by one owner to the other owners. A recent client engagement involved one of three shareholders selling out of the business, by way of a sale of their shareholding to the other two owners. This involved a professional business valuation, completed by an external professional. At the same time, the two remaining shareholders changed their shareholding percentage, so that one remaining owner held the majority shareholding, and the other held the minority shareholding.

Another example of equity funding is the introduction of a professional equity investment group. The ones I have worked with specialise in investing in businesses, remain as an investor for 5-7 years and then exit their stake in the businesses at a profit. For certain types of businesses, this can be an attractive option, particularly where the business owner(s) wish to build value to their business and then sell within 5-7 years to exit entirely.

The funder’s agenda

It is important to clarify the equity funder’s agenda.

  • Identify their track record and discuss the reasons they are willing to invest in your business.
  • Talk to other businesses the equity provider has invested in, to get a sense of how they have operated in the past and are currently operating.
  • Via frank, honest and open conversations, establish the timeframe of the equity investment. It’s also important to understand how the equity provider plans to exit from the business.
  • Ensure there is alignment with your style, expertise, investment timeframe expectations, approach driving exit and that of the equity investor. Are they looking for a passive investment, or do they bring management, governance and/or network skills and contacts?  Do they seek a more hands-on investment than you are willing to offer?
  • Are you and the equity investor looking to sell the whole business, or sell down a portion of the equity of the business? If so, do you both agree to the timing of this process?

Remember, if your equity investor is an individual, they could die or becomes incapacitated. You could then be faced with the prospect of dealing with the following people:

  • Their lawyer
  • Their trustee
  • The executor of their will
  • Their spouse
  • A mixture of all the above!

So select your equity investor with as much care as they will take to select you and your business. Ensure you cover-off all possible eventualities – nobody has a crystal ball.

 

Which option is best – debt or equity?

Sourcing equity investment involves skill, time and judgement. It may well be one of the most important and potentially pivotal business decisions you ever make.

  • Equity investment that works well, can deliver a business exit and liquidity that is exceptionally positive. Unfortunately, it can also go wrong. Equity funding is the most complex form of business investment known. It is best to approach carefully, with eyes open and superb planning and execution.
  • The balance of risk and rewards inherent in equity investment can, at times, make bank funding seem to be a more suitable alternative. The choice is up to you.

Murray Fulton often helps clients assess their funding needs and whether they need debt funding, or equity funding, or both. You can make an appointment for a no-obligation chat with Murray or contact him by email.

Read the next article in this series Bank funding – is your business bankable

Download Murray’s Ebook, Funding For Growth.