How do I decide when equity is required vs. debt?

The final article in our three-part capital structure series discusses a variety of advice that businesses can take on board with regards to reviewing your equity needs and assessing your efficiencies and opportunities that present themselves to you.

A lot of businesses look to maximise their debt before going to equity. Debt certainly puts a lot more of an obligation, particularly in regards to repayments, on owner managers so there’s definitely an inclination from shareholders to the management team to look at debt as a preference to equity. However, when looking at the plan of funding options it’s really important to find out at what point debt capacity begins to squeak and when the headroom runs out. If you then overlay that with sensitivity analysis to look at whether the business’ borrowing is or will restrict your growth, at that point it might be time to look at equity. For most businesses there will be clarity around that; debt is usually funded for an asset purchase or for growing the business in terms of working capital, but ultimately it’s usually very restrictive on the use of capital. Whereas if you’re looking to fund costs associated to marketing, entering new markets, recruiting a key hire or developing new products – then it’s more likely to be an equity proposition.

Generally speaking, more mature companies with predictable cash flows as well as limited investment opportunities should include more debt in their capital structure, since the discipline that debt can bring is more valuable than the need for flexibility. Whereas for companies that face higher uncertainty, e.g., high-potential fast growth businesses, typically should carry less debt, as the flexibility of equity enables them to take advantage of investment opportunities or to deal with unforeseen or negative events.

Our top tips to businesses:

  1.  Review where you are at the moment – take stock of the events from the last 12 months and work out what the next few months look like, what obligations you have, areas for improved efficiencies and freeing up cash. This will enable you to get clarity on where you are, and provide you with the information you need to work out the different options for how the business moves forward.
  2. Work out,as a team, what you want to achieve – some may want to take it easy and not risk too much while regaining stability and repaying debt. For other businesses, they’d gone from very difficult times after having to close their businesses on very short notice through to having a very successful year as a result of making their operations more efficient; for those business many are now looking to opportunities that can really accelerate their growth even further. What’s right will be very personal to each business, the wants, needs and capabilities of management, and the experience they’ve had over the last 12-18 months – it will be vital that these conversations are had and ensuring that everyone is on the same page about how you move forward.
  3. Further improve efficiencies where you can – Most companies can create more value by improving operational efficiency than they can with clever financing. Therefore, before looking to external debt and equity funding options, look at the existing business and identify if there are opportunities for further efficiencies or changes to your business model that free up unnecessarily ‘tied up’ cash.
  4. Assess what the opportunities are available to you – once you know the lay of the land, how you and your team want to move forward and have made any further improvements to working capital, then you are in pole position to be able to objectively appraise and pursue the opportunities available to your business that will help achieve the goals you’ve set out. Not all opportunities that are presented to the business will be the right ones to pursue and having these clear foundations in place will help navigate through some of these. However, when exciting and new opportunities come along it can be tempting to follow them – this isn’t necessarily a bad thing, particularly if it presents the prospect of differentiating from your competitors and value creation. Nevertheless, it is important to check that you are not simply chasing vanity so developing a process and ‘check list’ for opportunity appraisal can be invaluable.

This article was written by Phil Sharpe, a partner in the SCF team. If you believe you’d benefit from reviewing your capital structure but are unsure of where to start, or have done a review and want to know how to move forward, then please contact Price Bailey’s Strategic Corporate Finance team using the form below.

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide, and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.

 

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