Businesses tend to trade in cycles. Assuming an existing business model makes sense, there is generally an initial investment in the form of a shareholder or bank loan followed by a growth phase.
Once this growth phase matures, a further investment is necessary to achieve continued growth, either in the form of a working capital injection, or a property plant and equipment improvement, in order to avoid a growth plateau.
One size does not fit all
The size and scale of an investment required may vary depending on the life stage of the business.
While it may be sufficient to fund this expansion through the balance sheet initially, it is inevitable that a larger investment will be required, which usually entails a cash injection from an external source.
This can come in the form of either debt or equity capital. For the growth phase to be implemented successfully, it is crucial to understand which source of funding is suitable for the business at the time of the capital injection.
Unpacking finance through debt
Debt financing can be the quickest and easiest means for the cash injection, however it does come with some downside. Making use of a debt facility will result in term repayments as well as interest, sometimes at hefty rates depending on the loan size and term.
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This will likely have a negative effect on cash flows in-the-short-to-medium-term, raising the break-even point which immediately removes the possibility for debt finance for businesses which are near break-even point or whose trade tends to be cyclical.
However, because there is no change in shareholding, the returns at the maturity of the growth phase, once the debt has been paid off, will not be diluted.
In the case of cash flows not being a concern, the interest expense incurred in conjunction with the loan can also be used to reduce the company tax owed to the taxman.
The case for equity finance
Equity financing, where the cash injection is received in exchange for a relative shareholding in the business can be useful in unlocking far more value than debt under the right circumstances.
While debt can quickly accommodate a short-to-medium-term growth phase, the long-term benefits of finding the right equity partner can prove to be invaluable in achieving the businesses’ long-term growth plans, often by leveraging the new business partner’s synergistic business attributes.
The downside to equity financing is that the initial returns will be diluted as the new shareholder will be entitled to their portion of the earnings, however if one takes care to select the correct partner and advisor, the long-term returns of an equity partner can far outweigh the initial earnings dilution.
Partnering with the right adviser to determine the best source of external funding can ensure a positive outcome in the critical growth phase of a business.