what are the key differences between debt funding and equity funding and which is right for you and your business? and on what terms should you be taking either?
in a previous blog, I wrote about 5 sources of funding and promised to go into more detail on the differing types of funding between debt and equity. well this is it!
to briefly recap on my previous blog, I broke down different sources of funding into the 5 areas below. in each instance it’s important to ask what type of funding is best suited to your circumstances. this will help focus your attention on the type of lender or investor.
1. customers (and word of mouth)
2. staff (including family)
debt v equity
the simplest way to explain this is to ask the question – is the money is borrowed or not? debt is where you need to repay the amount borrowed (normally plus interest) and equity is an exchange of money for an investment or shareholding in the company.
in respect of equity you don’t have to repay the amount they provide but you do need to give them a percentage of your business (similar to what you see on Dragon’s Den). quite how much of the company you give depends on the valuation of your business, the amount of money they are providing and a lot of other negotiable factors. investors will expect a return on their investment instead of ‘interest’, which could include dividends or they take their share on exit of the business i.e. a sale.
let’s take a closer look at both debt v equity by answering a few questions which normally arise.
what happens if I can’t repay the debt?
if you have given security then the lender will take that security in place of the loan, this could be the assets of the company or a personal guarantee from directors – some loans don’t come with the need for security. but if it’s a large amount borrowed, be careful you haven’t secured it on your house!
what will the interest rate be?
it will vary on the size and length of the loan, plus if you have given any security. expect 4% to be on the lower end, 6-8% could be normal but up to 15% is seen for shorter, unsecured amounts. this will vary massively depending on many factors – due diligence before lending (i.e. speed loan will be given), investor portfolio, length of loan, size of loan, security, risk (i.e. your credit rating – what is the risk to the lender that you will default on the loan. the higher the risk, the higher the interest rate).
what % (equity share) of my company do I give up?
it will depend on the amount invested and value of the company. if receiving £100k investment and you value your business at £1m then 10% – it will be a negotiation for sure but ultimately it is the balance between what is someone willing to give you and what you will be willing to give up for the investment value. typically, the earlier your business is in it’s growth cycle, the more equity you will give away i.e. there is less of a track record for investors to be comfortable with.
is there a limit for each type?
nope, for debt you can get some very small loans from someone like Virgin Startup loans or crowd platforms (funding circle as an example) to multimillion £ deals from large debt providers and banks. similarly, with equity people will invest £10k in an early stage business they are excited about, a VC (‘Venture Capital’) or PE (‘Private Equity’) firm can invest tens of millions in companies at a time.
investing in your business with your own cash
you always have 2 options, either lend money to the company which can be repaid as and when or invest in the company in exchange for equity. a limited company must have some capital, but this could be £0.01. it’s harder to return capital where as a loan can ‘easily’ be repaid. however, a loan will be shown as a liability whereas equity is included in the company’s reserves, so will increase your net assets…unfortunately not a straight forward answer!
as a director/shareholder when you make a loan to the company, it is exactly that – a loan, so don’t forget you can repay this to yourself, with no tax implications of drawing the money out (unless you have been charging interest). a common area I highlight with business owners is how to efficiently extract cash from the business – through salary or dividends. you should also be mindful of these tax free limits when considering repaying a loan as the loan can remain year to year but the personal tax free limits are only for a year at a time.
the right investor for you
investors like it when you’re committed too, if your cash is on the line, to the same terms as theirs (or lower priority when being repaid) then you are showing commitment. a serious investor will have very clear expectations from their investment, for example a private equity house will have say a 3-5 year plan to exit, with a growth target so they know what they are expecting from their investment. does this fit in with your plans, can you handle the distraction from another party telling you how you should run your business? again, something else to consider when looking for an investor.
some growth accelerators, (seedcamp as an example), offer fairly fixed terms e.g. £20k – £30k for 5% – 8% of your business. however, in addition to the small cash injection, you’d also be part of their programme, the idea being to accelerate the growth of your business, getting access to some fantastic mentors as an example.
we could also get into the world of alternative finance, there are now so many options including invoice factoring (e.g. market invoice), rewards based schemes (e.g. kickstarter), crowdfunding (e.g. funding circle, money&co – debt, crowdcube – equity) and many more (including funding options which allows you to compare many different lenders)! there is too much to go into here, so I will write again on the different alternative finance options, but something you should explore!
in short, it depends what is right for your business and the purpose of any money you are looking to raise, as to whether you take the debt or equity route. hopefully this has given you some food for thought and if you are looking to raise money I’d love to hear about it.
thanks for reading – if you have any comments or questions on the above, or are interested in talking to us, please get in touch.