When is the right time to take on debt financing?
This decision for business owners is certainly not straight forward. Let’s face it, debt is often seen as a dirty word. We know it can have negative connotations of bailiffs and bankruptcies. Consequently, a lot of businesses are unclear as to what debt is exactly and therefore can be nervous about taking it on as a form of finance. However, it can be a very useful way of funding working capital and growth, de-risking shareholders and helping businesses evolve and scale. So this view needs healthy challenge and debate.
Here we hope to set out some key points when considering if debt is right for a business. We also hope to cover some basic points as to why and when in a company’s growth journey debt should be considered and the types of companies for whom it is more appropriate.
Which private businesses would you say are suitable for debt?
First and foremost, not all private businesses will be suitable for debt financing. Traditional lenders prefer businesses to have at least three years of cash-generative trading history, so potentially some time since the business was founded. Therefore, this can make it more difficult for early-stage businesses, especially those at the loss-making and pre-revenue stage who cannot demonstrate the ability to service the interest or meet any scheduled repayments. For lenders to consider a business ready for debt and present it to their credit committees there will need to be a demonstration of proof of concept, market stability, recurring revenue, credible financial forecasts and crucially, an ability to repay any debt provided through positive cashflow. Lenders will also need comfort in a strong management team, notably CEO, CFO and, where possible, some form of independent directors/shareholders to provide healthy challenge to the management team. Essentially, they need to be confident in the individuals who will drive the business forward and with whom they will build a relationship with over the life of the debt facility. When it comes to the actual amount of debt vs profitability, known commonly as leverage, then this can vary but lenders will have appetite for a level of debt up to a certain multiple of profit, with EBITDA the most commonly used metric.
What do you think are the main benefits of debt for businesses?
First of all, to be blunt, the cost of debt is cheaper than the cost of equity. Any debt that lenders provide will have fixed costs in the form of interest payments (which are tax deductible) and these incorporate an interest margin that reflects the lender’s perception of the risk on top of the cost of funds (eg Base Rate). With equity it is less clear as investors will expect a high return on their invested capital in the form of dividends, profits or future return on equity. The hidden cost of equity is higher than the cost of debt simply because equity is riskier for the investor as an unsecured creditor ranking behind any provider of debt.
Secondly, there is the benefit of transparency, i.e. how much is borrowed, how much needs to be repaid and by when, what is the interest rate and what security is required – all more visible and straightforward for companies to understand and prepare/budget for. There will be legal documentation provided by the lender for the business to sign that sets all this out clearly and an advisor should review it for the business before it is signed.
Further, access to capital and the authority to arrange it. Private companies, as opposed to those that are publicly owned, are able to make a decision about raising debt relatively quickly. With public companies, they are often constrained by a multitude of other stakeholders, including finance and treasury teams, non-executive directors, shareholders etc. This can create a very lengthy process, sometimes taking years, to consider and debate the pros and cons of debt.
Finally, control. Private business owners can retain more control by using debt without their shares being diluted through raising equity. Although lenders are ranked higher than shareholders in the event of default or liquidation, they do not demand a say in the running of the business outside of the financial covenants they ask the business to comply with and the control their lending documentation gives them. Lenders generally prefer to stay supportive behind the scenes whilst allowing management teams autonomy, although can provide strategic support and sector knowledge that can be helpful. They will obviously be concerned if the financial information they see shows the business is not performing as they had expected and would need to discuss this with the business with a more partnership-approach favoured.
What would you say are the key priorities for businesses when thinking about debt?
The key challenge for any business is making sure that if there is a need and a desire for debt, then it is arranged at a time that is right for the business. A common error is that it is pursued too early and therefore either time is wasted before a lender declines the request, or it is progressed but ends up not working out successfully. Preparation is key, with one example being the depth and quality of financial information produced by the business that lenders will expect to receive in support of the request across Profit & Loss, Balance Sheet and importantly Cashflow. Debt can be appropriate if the owners still see plenty of growth but do not want to exit and the immediate funding requirement is fairly moderate. It can also provide an element of financial rigour ahead of a future equity raise / sale further in the future. Even if the time is right then the level of debt taken on needs to be appropriate.
Every business will have its own debt capacity based on various elements including profitability, cashflow and tangible assets. Non-financial aspects are also important including client concentration, market competition and outlook. A deterioration in trading performance could lead to lower profitability, weaker cashflow and consequently the inability to service the debt, although it is unlikely that lenders would allow businesses to overleverage in the first instance to protect against this. Even if the time and level of debt are right, the actual product needs to be suitable for the business and its needs. There are various options available, including Revolving Credit Facilities, Term Loans, Asset Based Facilities and Invoice Discounting. These need to be considered and time taken to get the right product for the business and its needs.
How can finnCap Debt Advisory help private businesses at this time?
At finnCap we are able to give completely independent and impartial advice and we have experience of helping all types of businesses. We have a vast network of lenders that we work with across various types of debt products and transaction types. We engage with businesses to discuss what is best for them at their various stages of growth and the optimal time for their business to take on debt financing. From there we can help businesses decide the level of debt and what debt product is right for them. We help businesses promote themselves to lenders, access debt facilities and then complete the transaction. We help businesses to plan and prepare for an extremely important project in their evolution. The earlier this happens the better for the business and its preparation for raising debt facilities. A lot of business owners won’t have considered debt as a funding option, but it can be hugely beneficial if fully understood, taken at the right time, in the right way and from the right lender.
Find out more and get in touch to discuss your options.