Debt or equity?

Should you take debt or seek equity to grow your business? Given the current economic downturn, my answer has changed. Here’s why. ANDREW KENT

By Andrew Kent

The other day I was asked the perennial question by a business owner. He wants to grow the business. Should he take debt or seek equity to grow your business, given the current economic downturn?

In good times debt is generally referred to as gearing. In bad times, gearing is generally referred to as debt.

Gearing is generally referred to as a ratio – the amount of debt relative to the amount of equity. Debt is generally referred to as a dollar amount. The choice of words and references are chosen to make a point, but don’t change the facts.

The principle of gearing is simple; by financing the business with debt rather than equity, each share holding owns a larger share of the business than they would otherwise. This increases their level of exposure in good times and bad.

In good times it is praised as leverage and gearing, in bad times it is condemned as greed and debt. At any time people will also have a particular personal view on what the right level of exposure is.

One of the key measures of debt levels is called interest coverage. This is a measure of the proportion of the business’s cashflow that is consumed by paying interest on the debt. It is a measure that fluctuates with the performance of the business as well as the interest rate.

It also has a tendency to be a non-issue in good times and a substantial problem in bad times. Subsequently it is best used in conjunction with some financial modelling.

For example, what would it look like if the profits fell by 15% at the same time as interest rates went up by 250 basis points?

Deciding what mix is right for you

Whether you are buying a business or simply expanding, a key question is how you are going to fund it. The three simple choices are to either raise money through equity (selling part of the company to others), arrange debt finance (borrowing money), or a combination of the two.

As a general rule, at any given point in time, both will be of similar difficulty; that is if it is easy to get a loan, it will also be easier to find investors, and if it is difficult it will be difficult for both. Subsequently the choice of finance by publicly listed companies is not usually based on the business cycle.

However for privately owned companies the business cycle has more of a role to play.

While the ease of establishing debt and equity arrangements move in the same cycle, they do not end the same way, particularly in privately owned businesses.

Equity is forever. Business loans have terms, and what is bringing some highly geared companies some problems is that they need to refinance their loans in a tight financial market.

Equity based businesses do not have this problem as there is no requirement to refinance equity. Indeed it is the equity provider (the share holder) that has the problem at this point in the cycle.

If you are a private business owner looking to buy or expand a business at the present time, it is a good idea to be open to a range of debt to equity combinations. While it might sound a little strange right now, at this point in the cycle you might like to consider a preference for debt over equity within your given comfort range.

When the financial cycle turns to a much more positive phase, then it might be worthwhile to consider a preference for equity over debt.

Establishing your own range of debt and equity limits is essentially a personal choice. In part it will be influenced by the minimum level of ownership you are prepared to accept (such as 51%). It may also be influenced by the level of debt you are comfortable with and/or you are able to obtain.

Also consider the level of finance the business requires and the amount of interest it can afford to pay.

Whatever you decide you also need to be realistic.

Andrew Kent is a director of BizExchange, an independent marketplace for business for sale or seeking investment. BizExchange has a directory of independent advisers and business brokers and information on valuations.

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