Ways to fund a new business

TWO MAIN TYPES OF FUNDING

There are two main ways to get cash for a new business. They are called debt and equity.

• Debt is where someone (usually a bank) lends the business money. The business agrees to pay the lender back in the future. To make it worthwhile for the lender, the business agrees to pay interest while the money is being borrowed.
• Equity is where someone takes a share in the business. The equity investor gets a certificate to show the proportion of the business they own. To make it worthwhile for the investor, the business agrees to pay regular cash payments to investors. These are called dividends. The investor can also sell their shares for a profit.

COST OF CAPITAL

From the business’s point of view, both debt and equity have a cost.

• The cost of debt is interest, and is expressed as a percentage. For instance, if a bank charges 10% interest on a £100k loan, then the cost of debt for the business is £10k per year, expressed as 10%.
• The cost of equity is a mixture of cash dividends and enhanced share value, and is also expressed as a percentage. For instance, if an equity investor wants return (dividends and increased share value) of 20% on a £100k investment, then the cost of equity for the business is £20k per year, expressed as 20%.

AVERAGE COST OF CAPITAL

So that a business can monitor what return it needs to make for all investors, the cost of capital can be averaged. Taking the above example, let’s assume we raise £100k in debt, and £100k in equity, for our new business.

In this case, half the money is raised at 10%, and half at 20% , giving an average cost of capital of 15%. On average, for every £100 the business raises in cash investment, it needs to provide return of 15%.

DEBT OR EQUITY?

Which is best, debt or equity? There is no right answer, as every business makes its own decision, based on its balance of risk. Here are some pros and cons of each:

PROS AND CONS OF DEBT

• PRO: Debt is easy. If we own property to act as security, then raising a secured bank loan is relatively easy. The bank feels secure, because it can claim our property if we fail to repay the loan.
• PRO: We keep control. As long as we keep up debt repayments, we can keep all of our shares in our business, and therefore control, for ourselves.
• PRO: Debt is cheap. Because the lender is taking less risk than a shareholder, they require less return. Also, interest on debt is tax-deductible.
• CON: Debt is risky. If we fail to pay according to contract, then the lender can force us to sell our property, or even force us out of business.

PROS AND CONS OF EQUITY

• PRO: Equity is safe. Investors put their money into the business without a legal obligation for the business to give it back. And unlike loan interest, cash dividends are not payable if the business is in cumulative loss.
• CON: We give away control. Sharing ownership of a business usually involves sharing power.
• CON: Equity is expensive. We have to make sure investors are well compensated for the risk they are taking.

Roughly speaking, if we prefer control, and keeping the upside risk for ourselves, then we will prefer debt. In contrast, if we prefer safety, and avoiding downside risk, then we will prefer equity. If we are not sure, we may choose a balance between the two.

GEARING OR LEVERAGE

A business with lots of debt is described as ‘highly geared’ or ‘highly leveraged’. This means that a high proportion of their funds are contractually owed back to lenders.

High gearing or leverage generally means high risk.

Imagine that you know two friends, Charlie and Greta. Both of them own a house worth £1m. Charlie raised the funds from family, and has no bank loan at all. Greta, however, raised a bank loan of £1m, secured on the property. Which of them is at greater risk?

Obviously, Greta is at greater risk, because she has to repay the bank loan, plus interest, or else she loses the house. If the economy turns bad, it is Greta who may go bust.

With businesses, it is the same. Highly indebted businesses are very vulnerable. This is why credit rating agencies pay careful attention to indebtedness.

SUMMARY

There are two main ways to raise funds for a business, debt and equity. Debt is for people who like to keep control, and don’t mind risk. Equity is for people who don’t mind sharing control, and prefer to keep the downside risk low. Most people find their own suitable compromise.