SME Financing – Debt or Equity?
In working with SMEs, Business Finance Professionals will often be asked about options to secure funding for expansion and growth. Funding is a major hurdle for SMEs, with many unable to access the working capital they need to help increase revenue, improve efficiency and productivity, expand their service or product range or create an emergency buffer.
Unlike traditional brokers, Business Finance Professionals know there is more than one way for SMEs to fund new business opportunities or drive growth.
The two underlying options Business Finance Professionals and their SME clients have at their disposal are debt or equity – accessing business financing/borrowings or fundraising through investors.
Each option has its advantages and disadvantages, so careful consideration is required to determine which may be more suitable for the SME. Factors include the stage of the SME’s business, how quickly funding is needed, the process to access funding, required legal assistance, costs and the risks to the SME (as well as the lender or investor).
Debt Financing
Almost all Australians have had experience with taking on debt, be it a mobile phone contract, credit card, student loan or home mortgage. Typically, borrowings are repaid in instalments, at a predetermined rate over a set period.
For SMEs, there are some variations for debt financing, such as lines of credit and working capital loans.
SMEs can find it tough to secure debt finance given their risk level, potential lack of track record for generating profit, or perhaps not having a strong business credit score due to being a first-time borrower or having other existing debts. And, in the current climate, the banks and traditional lenders are tightening their credit analysis processes, making it increasingly difficult for SMEs to take out a loan. Where they are prepared to lend, banks are often asking for personal guarantees from the business owners and setting higher interest charges than for other lending scenarios.
Advantages of Debt Financing
Ownership and control are the biggest and most obvious advantages of debt financing compared to equity fundraising. With a standard business loan, the lender has virtually no control or influence over the SME. They may request information as a check to confirm ongoing financial viability and the ability to continue repayments. However, the SME owners maintain control of operational and business decisions and retain all the profits.
Another major advantage is that once the debt has been paid back, there is no continuing liability. With well-established lines of credit, SMEs can manage cash flow and borrow and repay exactly what is needed at any point in time, providing the comfort of knowing they can be debt-free and have the capacity to access additional funding as required. Indeed, analysis has indicated that using this type of debt can be the most cost-effective option.
A subsidiary, and often forgotten benefit of business debt, is that the interest component of the loan is tax-deductible, which can be useful for SMEs, especially as they start to generate positive returns.
Disadvantages of Debt Financing
The primary downside of taking on business debt is that the SME must make repayments regardless of their cash flow at the time. Even during low revenue periods, the monthly debt service still needs to be met, which can put tremendous strain on the SME and its owners.
Where lenders have insisted on personal guarantees, the impact goes beyond the future existence of the SME with family and lifestyle assets potentially at risk.
SMEs and Business Finance Professionals also need to realise and be prepared for the fact that the terms and conditions of loans can change, including lines of credit being called in. Changes in variable interest rates can also have an immediate and dramatic impact on a SME.
In addition, the amount of debt a SME holds effects profitability and the valuation of the business. Too much debt can scare potential buyers or equity investors away.
Equity Financing
Equity finance exchanges capital, from external investors, for shares/ownership in the SME. There are no fixed repayments to be made, rather the equity investors receive a percentage of the profits, according to the number of shares they have ‘purchased’ in the SME.
There are several types of equity financing for SMEs, with three of the more common being Private Investment, Venture Capital and Angel Investors.
The simplest type of SME equity financing is Private Investment from individuals. By offering shares to a select group of individual shareholders, the SME will remain a private company. This form of financing is often the most accessible as many SMEs are able to call on family and friends to invest. However, it can be tricky dealing with close, personal acquaintances. Relationships, both immediate and in the wider circle, can be put to the test and family and friends can be more forthright and imposing about the running of the business.
The goal of Venture Capitalists is to achieve healthy returns on their investment, often by using their knowledge and expertise to help the SME to grow quickly. Different Venture Capital firms specialise in certain industries; however, all are notorious for being hard to impress as they analyse many SMEs before deciding where to invest their time and money. For Venture Capitalists, their ideal investment is into a SME that is low risk and with a profit line about to skyrocket.
Unlike Venture Capitalists, Angel Investors are not interested in getting involved in the SME’s business. They are usually wealthy investors looking to provide large sums of money in return for substantial profits. They don’t want to, or necessarily have, any expertise or business acumen to offer. They just want to have confidence there is an achievable, solid strategy in place for the SME to grow and prosper.
For established SMEs who want to take things to the next level, they may consider offering shares to the public as a means of raising equity for further expansion. The process takes time, money and human resourcing and is only appropriate for much larger SMEs.
Advantages of Equity Financing
One of the primary advantages of equity financing is the amount of funding that can be secured. Compared to debt financing and traditional business borrowing, equity fundraising can bring in more capital. This can mean the difference between being able to undertake the expansion plans envisaged, launch a new service or product, achieve full sales potential or even survive a downtime.
There is no real cap on the quantum that can be raised through equity financing, and unlike debt, there is no continual and constant drain on revenue and profits. If the SME is not making a profit, then there is no debt to service. Further, there can be flexibility in shareholder distributions, with the decision made by the shareholders to retain profits to fund future opportunities. This can empower and free up the owners and management to make considered decisions and not be forced into unwise choices just because a loan repayment needs to be made.
Equity financing also brings in business partners - individuals who have a vested interest and potential knowledge, experience, connections and skills that can be pivotal in assisting the SME to become more successful.
Disadvantages of Equity Financing
Loss of control is the main concern when it comes to exchanging equity for capital. It can range from having others involved in business decision making all the way through to the original owners being replaced by equity partners if they are significantly diluted.
When there are equity partners, it obviously means the sharing of profits. And, in some cases, depending on the structure agreed upon, it can mean that shareholders can be entitled to profits before the SME owners are entitled to their share.
Finally, it should be recognised that equity fundraising can take time and effort. Whilst loan applications and paperwork can be tedious, the process of finding suitable equity partners and creating the documentation can be equally or even more arduous. Both are distractions and take time away from running the business.
Knowing the advantages and disadvantages of securing funding is a high-level, value-add service, that a Business Finance Professional can provide to SME clients. SMEs go through different phases and the best options can change with time and business maturity. The choices made now can also affect future funding options.
In conjunction with industry experts, elevateB has developed a self-paced, online, interactive Business Finance Certification. This program will provide you with the knowledge and skills required to become a successful Business Finance Professional and work in the SME space. In addition, it provides strategies and soft skills to assist you to better market and deliver your existing and new-found client offerings.
For more information on the Business Finance Certification, click here.