by Nabeel Chohan, AcceleratingCFO Consultant (UK)
Nabeel has extensive experience in management of financial reporting for global organizations, primarily within the technology, media and entertainment sector. Nabeel is a Chartered Certified Accountant licensed in London, United Kingdom.
Most growing businesses will reach an ‘inflection point’ where growth stagnates and liquidity becomes a scarce resource. When this occurs, financing is needed to expand operations and market reach.
Timing is critical — both in terms of raising funds and identifying the type of financial instrument that is best suited for the business. Multiple factors should be considered as businesses determine whether taking on debt is preferable to an unfavourable cash position in the future.
Due diligence and Control
The loan application and underwriting process for taking on debt is often lengthy and usually requires a history of the company’s financials and a current business plan — this will help assess the company’s ability to make regular repayments of principal with interest. If the terms include long-term debt, there might be a condition to provide yearly financials to the lender. Choosing this option minimally impacts the company’s key strategic planning and decision-making.
Equity financing, on the other hand, involves extensive financial, legal, and technical due diligence (DD) followed by regular reporting once the DD has been successful. The primary concern of issuing equity is the loss of control. Equity partners’ involvement is often an integral part of strategic/business planning, yet there is the inherent risk of being replaced by the shareholders if owners do not retain enough board seats and voting power.
With debt financing, the fixed repayments have to be made regardless of the company’s performance. Also, because the interest rate is volatile, it is prone to irregularity in the cashflow – which can impact the cash runway and could lead to unfavorable decisions, e.g. restructuring.
There are no fixed repayments to be made with equity financing. Instead, your equity investor will receive a percentage of profits according to their stock.
Debt finance usually creates a tax deduction due to finance charges and interest expenses which are usually allowable for corporation tax.
In the UK, the major pro for lenders investing in companies eligible for EIS/SEIS (Enterprise Investment Scheme / Seed Enterprise Investment Scheme) is the tax relief on Income tax and Capital Gains Tax (CGT).
In EIS, Income tax relief to the Investor is 30% of the investment value (max of £1,000,000) and no CGT to pay on the gain on Investment — and the investors can claim the loss relief in the same way. To be eligible for EIS relief, you generally have to hold the shares for at least three years before selling them.
In SEIS, Income tax relief to the Investor is 50% of the investment value and no CGT to pay on the gain on Investment — and the investors can claim the loss relief in the same way. To be eligible for EIS relief, you can only invest up to a maximum of £100,000 and generally have to hold the shares for at least three years before selling them.
We will cover both EIS and SEIS in greater detail and popular types of debt securities in our next blog.
There are pros and cons for both debt and equity financing. The choice truly depends on your specific business needs and which is most advantageous both in the short and long-term. When making these decisions, the right business support expertise is critical.
Takeaway: Please let us know if you’re deciding to raise capital for your business. AcceleratingCFO can walk you through a number of scenarios that would be beneficial for the business and its stakeholders now and in the future. You can reach us at firstname.lastname@example.org to schedule a free consultation on your capital structure and how it can be recapitalized to maximize your company’s potential.