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Debt Vs Equity: Growing Business Sustainably

16/09/2014 12:46 BST | Updated 14/11/2014 10:59 GMT

Choosing to raise finance through debt or equity is a step that many SME owners and directors have to make at some point.

Lending from major banks to smaller businesses has steadily declined over the last four years, contributing to an explosion in alternative finance formats available within the UK and a marked change in the business financing landscape.

Now directors seeking financing for their business have a wider range of funding options available, which can further complicate the issue of whether to use debt or equity.

Why choose equity funding?

For private companies finding an angel investor or an equity partner are two traditional ways to access equity funding. However, between 2011 and 2013 equity-based crowdfunding increased in volume by 317%.

Although all three funding channels achieve the same goal, they do so in very different ways. Releasing equity to an angel investor or an equity partner can provide more than financial support. These investors are committed to a business's success and will often provide strategic support and mentoring, which can be invaluable to a business in the early stages of growth.

The flipside is that this can bring a considerable loss of autonomy for business owners, meaning that both owners and investors have to share similar long-term strategic aims for the business.

How does equity crowdfunding change the game?

Releasing equity through crowdfunding is unlikely to provide the same level of support as an angel investor would, but it can give innovative businesses a channel to raise large sums of money without having to relinquish control.

Brewdog is one UK company that crowdfunded equity extremely effectively. The independent brewery created a unique programme called Equity for Punks, independently selling shares in their business online, enabling them to expand operations and leading to 95% year on year growth in 2012.

There are a several factors companies looking to replicate Brewdog's success need to take into account. The company attracted attention to their offering through sustained use of both social media and traditional marketing, a significant hidden cost of a crowdfunded equity release.

As Brewdog sold shares through their own website they also needed to register with the FCA.

Even with crowdfunding, owners still relinquish a certain amount of control over their company. Typically, larger investors get shares with full-voting rights (sometimes called 'A-Class' shares), meaning that they can affect company strategy at AGMs and shareholder meetings. Smaller amount investments entitle people to dividends-only non-voting shares (sometimes called 'B-Class' shares).

As with any shareholder, it's reasonable to expect that the business's profitability and consequent ability to pay dividends will be a major concern. Before deciding to release equity businesses owners need to carefully consider whether this demand for sustained profitability and dividend payments will clash with or complement their long-term business strategy.

Why choose debt financing?

85% of UK businesses use debt to finance themselves, often through a bank loan or overdraft according to a study by the European Commission. Its popularity is due to being so widely known, relatively simple to apply for and because it doesn't dilute ownership. Having said that, in order to qualify for a loan business owners need to present a plan for development which is acceptable to their lender.

Tyrrells crisps, one of the biggest small business stories of the last ten years, grew on the back of an £800,000 loan which was secured against the founder's potato farm, which allowed him to build the company's first factory.

The problems with debt financing

One of the biggest drawbacks for SMEs is the difficulty which they have accessing credit from major banks. The European Commission report highlighted that 32% of SMEs who applied for loans didn't get the finance they hoped for, either being turned down entirely or just getting a fraction of the money they asked for.

This is such a widespread phenomenon that now business owners are simply not applying for bank loans or overdrafts because they believe they will be turned down. In the first quarter of 2014 48% of would-be business borrowers were so discouraged about their prospects of getting credit that they didn't even apply.

Another 36% of business owners chose not to apply because the process was too time-consuming, credit was too expensive or it required security.

Bonds: the alternative to bank loans

Corporate bonds have long offered large companies an appealing alternative to bank loans and overdrafts and the advent of offering peer-to-peer and crowdfunding platforms makes it possible for smaller businesses to access this form of finance.

As companies only need to make interest payments during the life of the bond, they are able to keep more money in the business, which can be useful if owners are planning on long-term, capital-intensive development.

Bonds also offer a stable interest rate, allow owners to retain control of the business and interest payments are tax deductible.

The main disadvantages are that interest repayments are balanced against cash flow (which could make the business less attractive to lenders if further financing is sought), that they reduce dividend payments and are sometimes secured against business assets.

Despite the tightening of bank lending, SME owners have more options than ever before for financing their businesses. The most important factor is to ensure that the opportunities and restrictions of the type of finance chosen align with the company's long-term aspirations.