Choosing between debt or equity finance, or a mixture of the two, could be the most important business decision you ever make. SmallBusiness.co.uk speaks to entrepreneurs, financiers and advisers about the pros and cons of each.

Choosing between debt or equity finance, or a mixture of the two, could be the most important business decision you ever make. SmallBusiness.co.uk speaks to entrepreneurs, financiers and advisers about the pros and cons of each.

One May morning on the island of St Agnes, just off the north coast of Cornwall, entrepreneur Charles Armstrong heard a knock on his door. Armstrong, an ethnographer, had been studying communication networks on the island and figuring out how large companies could mimic their efficiency.

The knock was from Warren Langley, former president of the Pacific Stock Exchange and proprietor of an early-stage investment fund. News had reached Langley of Armstrong’s project, and he led the first round of seed funding into Trampoline Systems in 2003, raising £200,000.

Langley’s involvement with Trampoline, the company that commercialised Armstrong’s original research, is a classic example of when equity financing works wonders. ‘If Warren hadn’t turned up on my doorstep, there would have been a significant chance I would have developed the product as an open-source venture,’ says Armstrong. ‘He’s been very influential in determining our strategic direction. In our first year of operation, we took up about 30 per cent of his time, though he was technically a non-executive board member.’

A second round of seed funding in 2006 provided a bridge to the Series A round in March this year, when US venture capital firm Tudor Group backed Armstrong’s venture with £3 million.

‘I went through a phase when I was really down on the idea of taking the VC route,’ Armstrong admits. ‘I did hear some horror stories from friends.’

His misgivings proved unfounded: ‘They invited us to propose someone to be a board member to represent their interests, rather than imposing someone on us.’

According to Andrew Killick, head of corporate finance at advisory firm Baker Tilly, an owner’s mindset is often the deciding factor between debt and equity.

‘Your first question should be: is it even acceptable to you to share the cake?’ he says. ‘That will exclude a certain proportion of the population. Someone who’s come out of a large corporation, for instance, may feel that they never want to “report to someone else” again, or have someone looking over their shoulder at what they do.’

Growth choices

It’s a view well understood by Spencer Gallagher, founder of digital design agency Bluhalo, who funded his business from redundancy money of £4,500 and now brings in turnover of £2.5 million. Gallagher scraped by on bank overdrafts for years – not without difficulty – but as a result still owns 100 per cent of his business.

‘My view was that we had to prove the business before looking for external investment,’ Gallagher explains. ‘Since we were listed in [professional services firm] Deloitte’s top 50 tech companies we’ve received about 400 letters saying, “Would you like our money?” But to sell a stake and lose overall control, you have to make sure the benefits are there.’

Like Armstrong, Gallagher has heard horror stories from friends about VCs ‘putting in their own team of people, then trying to take over the business’. But at the same time, he realises that debt may be insufficient to meet his own aspirations for Bluhalo.

It’s left him with a dilemma as the larger agencies he wants to compete with are strengthening through consolidation. If he is to achieve his stated ambition of becoming the number one agency, additional third-party funding will be required.

Nearly every ambitious owner-manager will confront this crossroads. Though private equity’s focus, leverage and contacts can help you turbocharge your business, the price you pay for its services is high. Usually it’s a majority stake in your company, claims John Gregson, a director of the corporate finance arm of Deloitte.

‘In the corporate finance transactions we’re involved with, virtually all the private equity houses would be seeking majority control,’ he says. ‘There are a couple that would invest on a minority basis, but that’s typically for larger, more stable businesses.’

Whether private equity will grow or shrink an owner-manager’s individual wealth comes down to a simple calculation, according to Gregson: how much can you grow the business with the additional equity, and how much can you grow your stake? If you get your sums wrong, you’re liable to be left with less than you’d have made by following a policy of less aggressive growth.

Gregson also points out that the interest paid on debt is tax-deductible, making the real cost less than the apparent cost. When you’ve factored in the hefty lawyers’ and advisers’ fees for arranging private equity deals, and other associated outgoings, debt’s cost advantage over equity becomes even more marked.

Debt has its problems, though. Apart from being susceptible to rising interest rates, it sometimes just isn’t available, as Charles Armstrong attests: ‘If you’re a big, mature company, the mainstream banking system has the appropriate instruments for you.

Likewise, if you’re setting up a corner shop, it’s a business that’s well understood and banks can help. But if you’re an early-stage, research and development-intensive start-up, the banking system isn’t much help.’

In fact, you may be hitting your financial targets and still struggle to secure debt. Gallagher, for one, encountered difficulties notwithstanding Bluhalo’s record of profitable growth.

‘Two years ago our turnover reached £1.6 million. I went to the bank to ask for an extension to our overdraft facility,’ says Gallagher. ‘The statement I got back from them, which I’ve heard many times since, was: “We’re not in the business of taking risks.

You’re the entrepreneur and you’ll end up being the millionaire, but what will we have to show for it?” I suppose I could see their point.’

Gallagher’s bank would only lend him money on the basis of additional personal guarantees, which, as Baker Tilly’s Killick points out, are ‘a kind of quasi-equity’.

‘If you have to go down the route of giving personal guarantees, the bank is effectively saying “the risk’s too high for us”,’ he states. ‘You’re having to surrender some of your asset base to get the funds in.

‘This could have a big impact on you personally. Your private equity partner won’t be pleased if you lose all your money, but if you’ve run the business properly, there’s not a lot they can do about it. Whereas with banks, if you don’t make your loan repayments, the banks really don’t like it.’

Shop around

The big banks, of course, are not the only place to go for a loan. Asset-based lenders, investment banks and even venture debt providers (which lend only to VC-backed businesses) are moving in on their territory. Gary Edwards, head of the growth and acquisition finance team at Investec Private Bank, argues that such institutions can sometimes take a more flexible view of risk and reward.

‘Our first decision is on the management team and what they are trying to achieve,’ he explains. ‘Our second question is: do we find the business proposition compelling? Thirdly, we look at the financials and debt structure.’

Should Edwards and his team decide to back a business – and they back between 12 and 24 each year – they’ll agree on a structure of either ‘amortising debt’ (in other words, a fixed-term loan) or ‘revolving debt’ (for example, invoice discounting), or both.

If the risk profile warrants it, a little equity may be thrown in, or perhaps ‘mezzanine finance’, which lies between conventional debt and equity in its cost and tolerance of risk.

Edwards believes that structuring a flexible package is vital. He says: ‘As an entrepreneur, you might see a perfect opportunity for your business that would cost, say, £100,000 to set up. If the burden of debt repayment affects your ability to make that investment, there’s something wrong with how the debt was originally packaged.’

Operators like Investec, which has an attitude to risk somewhere between a traditional bank and a venture debt provider, and more sophisticated financial instruments like mezzanine, reflect the blurring of old boundaries between equity and debt.

Baker Tilly’s Killick reflects: ‘A number of banks have specialised teams focused on [unsecured debt], but it’s a grey area because there tend to be higher rates or kickers which hand the bank some of the equity in the case of a default. Similarly, private equity might put some money in as debt or a mezzanine loan.’

As the funding needs of businesses grow, it becomes increasingly likely that both debt and equity will be needed to fill the gap. There are exceptions, of course, and Shield Environmental Services, a Bristol-headquartered specialist in asbestos removal, is a good example.

Debt financing

Established in 1979 by brothers Philip and John House, the company underwent a management buy-out (MBO) last year, which was funded almost entirely by debt. The purchase price of £11.2 million was raised by a five-year loan of £4.5 million from the bank, plus loan notes and preference shares issued by the vendors.

Ian Hewer, Shield’s marketing director and one of the MBO team, explains: ‘We were courted by a number of VC companies and looked at the different options, but the management team didn’t want to lose control of the business.’

Daniel Kitter, the company’s financial controller, adds that debt worked out far cheaper, especially as the bank loan was secured at only 2.25 per cent above the Bank of England’s base rate.

He says: ‘Shield enjoys a privileged position because asbestos is still a relatively niche market and the margins are pretty healthy at a minimum of 15 per cent. That makes it easy to service the debt.’

In the first year, post-MBO turnover is up to around £14 million – results achieved by ‘damn hard work’, according to Hewer, who considers the growth proof that the current management team have the necessary skills to run the business without external help.

Bringing in private equity does lead to pressures as you operate to a set schedule. According to Killick at Baker Tilly, private equity funds have become less patient than they used to be: ‘Historically, private equity looked for an exit in five to seven years. Now it’s frequently three to five years, though a few look for longer-term investments – 3i for example. With a debt provider, though, there is no forced sale as long as the business is reasonably successful.’

For all its demands, private equity can confer a prestige on a business that debt never could. Will Franks, founder of mobile technology specialist Ubiquisys, has raised $37 million (£17.8 million) of venture capital for his business from Atlas Venture, Advent Venture Partners, Accel Partners and, in its latest funding round, Google.

‘Google’s investment gives a signal to the market about the type of company we are. It gives credibility not just to us but to this whole new sector of the market,’ says Franks, whose technology aims to improve mobile phone reception in the home. ‘The likes of Vodafone and Orange aren’t going to invest in a company that is backed by investors who aren’t credible.’

Franks adds that the VC investment in Ubiquisys has helped the company raise debt: ‘The best advice I’ve been given is to raise debt when you’ve just got a load of equity in the door.’

Just as the leverage offered by debt can enhance equity returns, it seems strong VC backing can be the key to securing debt. Increasingly, the choice faced by owner-managers or would-be MBO teams is not between debt and equity, but about choosing the partners who can structure an appropriate mix between the two.