Good vs bad: making the right debt choices

Bank - Business FinanceDebt is sometimes seen as bad business, but it can be a great way to gain a competitive advantage by providing the capital needed to seize opportunities that the company couldn’t normally afford, such as inventory or a large piece of equipment or taking on much needed help. However, how much debt your business takes on always needs to be weighed up carefully and your loan repayments need to be managed efficiently to avoid exposing the company to risk and increasing the chance of business failure.

Business lifecycle

The type of debt that you can access typically depends on where your company is in its lifecycle. Start-ups are usually dependent on initial investments from personal savings combined with some bank debt, such as a start-up loan. However, as the company grows, you will most likely turn to equity financing from venture capital firms, for example, to take the business to the next level.

Once a company starts to mature, potential investors are less likely to buy stakes in the company because the rapid growth associated with new businesses has slowed along with the potential for high returns. However, at the same time that angel investors lose interest, banks are keen to lend you money cheaply because the company is now established, has a steady stream of profits and is likely to have solid collateral to secure the loan. In short, it’s a much safer bet.

More mature companies, therefore, are more likely to rely on bank debt at this stage of the business lifecycle.

Get bank debt

Borrowing money from the bank involves returning the principal plus the agreed percentage of interest to the lender through equal monthly repayments up until a fixed point in the future. One of the major benefits of bank debt is that it’s relatively cheap compared with other forms of finance, such as business credit cards and equity financing. Another plus is that interest paid on loans taken out by a business is a deductible expense, making the cost of borrowing even lower.

However, the downside of bank debt is that if the company fails, you will still have to find a way to make the payments and if you fail to do so this could have a serious impact on your business financing in the future, from the loss of assets to cover the cost of defaulting to having a negative impact on your credit rating, which dramatically reduces your business finance options in the future.

If you can keep up the repayments, a business bank loan is definitely good debt as it’s a wise investment in the financial future of your business, which creates value by being tax deductible and can produce a positive return on your financial position in the long term. However, if you aren’t disciplined or ready for the long-term commitment of a bank loan or aren’t at the right stage in the business lifecycle to take on debt, there are other options that should be explored to secure financing for your business.

Get equity financing

This type of finance raises funds by selling stakes in the company to one or more investors. Unlike bank debt, instead of making regular fixed monthly payments with interest, you only need to compensate investors/shareholders if and when your business makes a profit. When this happens, investors must be given a previously agreed percentage of your profits, which is typically 10%, for the duration of your business or until they choose to cash out.

One of the benefits of equity finance is that you have no legal obligation to pay a dividend even a small one if the company’s cash flow position is weak, which gives you some breathing space. As a business owner, however, the percentage agreed can work out to be really expensive and dividend payments are not tax deductible. As an investor, much of the return on the equity investment is tied up in the appreciation in the value of the stock, which requires the company to grow its sales, revenue and profits.

Equity, without a doubt, is a more costly source of finance, especially compared with bank debt, largely because of the high risk of the investment. Should the company become bankrupt, the investors that provided equity funding are the first to lose their investments. Of course, an equity investor offers much more than just cash, you will benefit from their years of experience, knowledge, industry expertise, commitment to their investment, connections and long-term support, which makes equity finance much more appealing than bank debt.

The one big drawback of equity financing is that Investors won’t want to participate in the running of the company, but will will want have a say in the strategic planning of the business to reduce risk, maximize profits and protect their investment. As a business owner, sharing control of the business needs to be carefully considered.

When it comes to securing finance to expand your business or to get the next great business idea off the ground, bank debt and equity finance are the two most obvious options, but most entrepreneurs try to create a balance between the two in a way that pushes the company forward yet keeps the total cost of debt low.

Mike Smith

Mike Smith is the director of Company Debt, an insolvency and company rescue specialist who are amongst the UK’s most experienced mediators with HMRC.

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