Why debt funding is sometimes the smarter option
With Covid-19 holding its grasp on the world, economies have slowed down. Among the worst affected are small companies and startups who are cash-strapped.
While some have taken the inevitable route of layoffs and pay cuts, many are trying hard to find funding which will increase their runway. And, when it comes to funding, most startups and companies seem to go the equity way. In these uncertain times, being able to access equity capital is often proof of a strong business. Hence, it should be the primary choice especially in cases where the business is badly cash-strapped and staring at long term uncertainty.
However, our experience has shown us that even in times like these, a blend of equity and debt can actually be the more effective option.
In a normal situation, opting for debt is healthy for a growing company. It helps in planning ahead, as the company is aware of its repayment obligations, and is often more cognizant of measures it needs to take to survive and grow. In uncertain times, debt in combination with equity, creates significantly more value than equity or debt alone.
Debt financing comes with its own benefits. Here are some reasons why debt funding is sometimes the smarter option.
Cheaper than equity
Often, many businesses face situations where they need some funds to keep the business going, even though the business itself is strong. This is usually on account of working capital gaps, where your suppliers need to be paid before you can realise cash from your customers or dealers.
Raising financing for meeting working capital gap helps businesses grow effectively but for any entrepreneur or business, cost of financing is very important. While the cheapest form of financing a business is profits, when you want to fast track your business growth, debt funding is the next cheapest form of capital.
When a company is growing fast, generating healthy cash flows, and has a controlled burn rate, debt can be a cheaper form of financing that can save the promoter and early investors from further dilution at unfavorable terms. With equity funding, the business owner and early investors sacrifice shares in the existing and future value of the business. Whereas, with debt funding, the business incurs capped interest costs that are temporary, which leaves the value created in the business to be harvested by the promoter.
In addition, for a profitable business, interest costs will help in reducing the taxable profit.
Retain control over business
When companies choose equity funding, in addition to entrepreneurs having to forgo their share in the business, they end up losing partial control over it.
As shareholders in the business, equity investors have the right to influence the strategy of the company. This can also give rise to new conflicts within the organization, and sometimes result in disastrous pivots that often don’t retain the founders’ early vision or DNA. The investors on the company board should be considered before taking any decisions.
However, with debt funding, there is no fear of losing control over the company.
One key factor that plays a major role between equity and debt funding is time.
There is no denying that equity funding brings in patient and long term capital. However, organizations do agree that raising equity funding is time consuming, whereas raising debt is comparatively quicker.
Raising equity capital is difficult and a much more cumbersome process, sometimes not resulting in any funding at all. However, when it comes to debt funding, it is relatively easy and businesses can borrow small amounts for quick expansion, even with no collateral, so you have more time on your hands to run your business, and without any external pressures. Even if there is a decline at the end of the debt process, you come to know of it sooner.
As mentioned earlier, there are tax benefits of debt funding for profitable companies. Going for debt funding helps organizations reduce the taxable profit, which will further reduce the tax expense. This will also make the effective interest rate lower than the headline interest rate.
Many organizations use this strategy to improve the returns on equity investments. This will also help small businesses improve their company’s finances.
Encourages financial discipline and business efficiency
Debt funding pushes organizations towards financial discipline in running the business leading to improved predictability of long term success. It helps the company grow to its full potential while ensuring there are no slippages early on.
Overfunding with equity sometimes gives the psychological comfort to splurge on non-value additive initiatives, while if the same funding is raised through debt, it forces the business to be mindful and ensure that every decision that businesses make is financially justifiable.
It is always advisable to study all options of available capital well. One needs to understand the growing needs of the company and plan for short-term survival and long term value creation, and it’s advisable to consider a mix of equity and debt, depending on short and long-term goals of the business.
Equity is long-term and patient capital, and hence should be used for long-term investments where the timing of cash flow is not certain, such as in new product development, new business line or situations of long term uncertainty like today. For use of funds where the timing of cash flow is more predictable, (eg: working capital, purchase of assets which result in immediate cash flow, or bridge finance where equity is tied up) debt is more appropriate as it helps the business conserve valuable equity.
Both situations co-exist in most businesses.
Strong businesses have a clear capital strategy in place, and whenever there is an opportunity, they leverage a portion of the equity capital to raise debt. In fact, this improves returns for the equity investors and is hence seen positively by future equity investors. Our experience shows, companies that have raised debt from more than one source are more likely to raise another round of equity.
In difficult times like now, it is not just the product, process and marketing strategies that matter for businesses. It is also an appropriate capital strategy that ensures their very survival and long term value creation.
Avishek Gupta is investment director at Caspian Debt. The views in this article are his own.