Cash injections for your business – debt or equity?
Your business may require an injection of capital at any point in its lifecycle and now more than ever there are a wide range of options to choose from, all of which carry their own benefits and risks. These financing options can be split into 2 distinct categories: loans/debt finance and equity investment. We will consider both of these options below.
A loan is an injection of cash into the business which is then required to be repaid to the lender by an agreed point in the future, either in one lump sum at the end of the loan period or in regular installments. The cost to the business of the loan is an interest charge which is calculated as a percentage of the loan value, along with any one-off set up fees and ongoing arrangement fees.
Whilst historically loans have mainly been provided by banks, the internet has opened up additional sources of loans from websites offering peer to peer lending. This creates greater access to financing for small or new businesses who typically would not meet the requirements imposed by banks on lending.
The cash amount for a loan will be shown as a liability on your balance sheet, and the loan interest and associated fees will be expensed in the income statement over the term of the loan, therefore reducing profit. For tax purposes the loan interest will reduce the taxable profit of the business, reducing the tax charge paid.
However, recording debt on the balance sheet will impact on the gearing levels of your business, which is a key measure of financial stability. The lendor might impose covenants whereby the business must achieve agreed targets for the gearing ratio (total debt divided by total equity) and the interest cover ratio (profit before tax and interest divided by the annual interest charge) and this might limit the amount that can be borrowed, or in fact prevent borrowing at all. In addition, failure to achieve these could result in the loan being recalled.
Whilst debt financing allows you to retain full control of your business, as we’ve seen above it is subject to high levels of scrutiny and there may be constraints imposed by the lendor.
An alternative financing option would be to sell shares in your business to investors. The business in return will receive a cash injection without having debt on the balance sheet or having to pay ongoing interest or loan repayments. The cash amount would not need to be repaid as with a loan agreement.
Issuing share capital will increase the equity shown on your balance sheet which will dilute the control given to the existing shareholders. Equity investors will typically expect to receive a dividend from the business which can only be paid if the business has sufficient distributable reserves i.e. is making a profit.
The issue of share capital will have a positive effect on the gearing ratio if the business has existing debt on the balance sheet as the equity value of the business will increase, and there is no impact on profit as dividends are paid from reserves. However dividends are not an allowable expense for taxation purposes and will therefore not reduce the corporation tax charge.
Whilst an equity investment will reduce the control within the business for existing shareholders this does not necessarily mean they will lose overall control, assuming over 50% of the shares are still held. In addition, equity investors such as business angels and venture capitalists can often offer expertise to your business which would not be available from debt lendors such as the bank. This can result in an expectation that they will be allowed a high level of involvement in the day to day operations of the business, and as such you may feel greater scrutiny from the investors that would be felt from a debt lendor.
As with debt finance, the internet has enabled businesses to access alternative sources of equity finance, and one of these is equity crowdfunding. Equity crowdfunding allows for access to a much larger pool of investors through shares being offered for sale on a regulated website to the general public.
Which option is best for my business?
Unfortunately there is very rarely a straight answer to this question!
The finance option that is best for your business will depend on the current financing arrangement in place and what the investment is required for.
Equity investment is often seen as an option once your business has exhausted all current loan borrowing facilities, although this does not always need to be the case. After taking into consideration both the accounting and tax implications, along with the benefits highlighted above, equity investment might be a preferable option to taking out a loan under some circumstances.
The best place to start in making any decision is to understand all the options currently available to your business, and discuss these with your finance experts to ensure that the decision made is the best fit for your business at this current time.