Is debt or equity funding best suited for your acquisition strategy? | Shawbrook

When businesses seek acquisition finance, they must consider two funding options: debt and equity. Each option has its own set of benefits and drawbacks, and the choice between them depends on various factors, including the company's financial health, growth strategy, and market conditions. This article explores both debt and equity funding, comparing their advantages and disadvantages to help businesses make informed decisions.

Why opt for debt funding?

Debt funding involves borrowing money that must be repaid over time with interest. Common forms of debt used by SMEs for funding acquisitions include corporate leveraged loans, unitranche loans, and asset-based lending.

Benefits

• Retained Ownership: Debt funding allows the business owners to retain full ownership and control of the company, as lenders do not typically take an equity stake.
• Tax Advantages: Interest payments on debt are often tax-deductible, which can reduce the overall cost of borrowing.
• Predictable Repayment Schedule: Debt agreements typically have fixed repayment schedules, providing clarity on future financial obligations
• Leverage: The use of debt can amplify returns on equity, as the business can grow without diluting ownership or increasing the level of equity committed to the business.

Drawbacks 

• Repayment Obligations: Debt must be serviced and repaid regardless of the company's financial performance, which can strain cash flow, especially if there are unexpected downturns.
• Interest Costs: The cost of borrowing can be significant, particularly for businesses with lower creditworthiness or if there is economic volatility which causes market or Bank of England interest rates to rise (where the businesses debt is based on floating rates).
• Covenants and Restrictions: Lenders will typically require covenants and restrictions that mandate the business adheres to certain requirements or refrains from certain activities without prior agreement, limiting operational flexibility.
• Risk of Over-Leverage: Excessive borrowing can contribute to business underperformance by consuming free cashflow, increasing the risk of financial distress or bankruptcy.

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Why might equity funding be preferred?

Equity funding involves raising capital by selling shares of the company to investors. This can be done through a variety of routes and to different types of investors, including high-net worth individuals, private equity, venture capital, or a broader set of institutional investors via public offerings.

Benefits

• No Repayment Obligations: Unlike debt, equity does not typically require any fixed repayments, reducing the financial burden on the company.
• Access to Expertise: Equity investors often bring valuable expertise, industry connections, and strategic guidance to the business.
• Improved Financial Health: Raising equity can strengthen the company's balance sheet, making it more attractive to lenders and other stakeholders.
• Flexibility: Equity funding provides more flexibility in terms of use of funds, as there are no covenants or restrictions imposed by investors.

Drawbacks

• Dilution of Ownership: Issuing new shares to new investors dilutes the ownership stake of existing shareholders, potentially reducing their control over the company.
• Higher Cost of Capital: Although there may be no formal repayment obligations, equity investors will expect a return via dividends or other routes and their return expectations will generally be higher than for debt, making equity a more expensive solution.
• Pressure for Performance: Given the higher return expectations from equity this can create pressure on management for rapid growth and performance.
• Loss of Control: Bringing in new equity investors can lead to a loss of control, as they will typically expect some level of influence over key business decisions.

What preparations are needed in advance of raising new debt or equity funding?

Whichever option is chosen, the business will need to prepare for this important step. Whether working with an existing partner or securing a new funding relationship, a few key areas are worth considering:

• Management team: A funder will assess the business, not only in terms of its financial performance but also management. An established team with a clear business plan and an experienced finance director will be invaluable to a successful fundraising.
• Management Information: In-depth checks on the stability of the business will be completed and this will require integrated forecasts of future revenue, profitability and cashflows. The company’s accounting and financial systems will need to be robust and efficient to deliver this reporting both initially and on an ongoing basis.  
• Advisory support: Working with a subject matter expert may help assess the merits of the different financing options, answer any questions and help to streamline the process. Advisory firms can also assist with finding a suitable funder and support with longer-term plans or strategic funding requirements.

Conclusion

Debt and equity funding both have their own advantages and disadvantages, and the choice between them depends on the specific circumstances and strategic goals of the business. Debt funding may suit companies looking to retain full control and leverage their existing financial performance, while equity funding may be preferrable for businesses looking to strengthen their balance sheet or focussed on accessing strategic expertise. A balanced approach, combining both debt and equity, may also be considered to optimise the benefits and mitigate the drawbacks of each option. Whichever route is chosen, the business will need a solid reporting system and a strong management team to progress the transaction.