Debt versus Equity - Financing for SMEs

The need for additional finance is often the price of success for small to medium-sized enterprises (SMEs) that are looking to grow.

The question that faces the directors in such a situation is whether to go for debt financing, which will appear as a liability on the balance sheet – and possibly preclude further borrowing – or for equity funding, which will not. Securing equity finance may, however, entail giving away control of much of the business, leaving owner managers as little more than employees.

Inevitably, both forms of financing have their advantages and pitfalls – which may be hidden in some long and complex document that it takes a legal expert to decipher.

Check for penalties

One of the advantages of debt financing is that SMEs are able to schedule their repayments – although it is always worth checking that there is no penalty for early repayment of the total sum involved and that there is no huge payback at the end. Companies know what they will be required to pay back over a set period of time.

Another pro is that the SME retains control over the company.

Lenders will want to make sure their interests are protected as securely as possible. Debentures are a common method of obtaining security and, with their combination of fixed and floating charges, they are intended to meet the need of SMEs for increased working capital by allowing additional borrowing secured on the circulating assets of a trading business.

A debenture is widely accepted as a necessity for many corporate lending arrangements where there is not enough security over property alone for the lender to feel at ease.

The key distinction between a fixed and floating charge is that a lender has control of the assets subject to a fixed charge, while the borrower retains control of those assets (such as raw materials or stock) that are subject to a floating charge.

In practice, this means that an SME cannot buy or sell fixed assets without the approval of the lender but can deal with assets over which there is a floating charge in the ordinary course of business.

Onerous covenants

Lenders will insist on covenants, warranties and representations and these can be very onerous. Covenants, for example, can be restrictive or financial and within these categories can be affirmative or negative.

Affirmative covenants require the borrower to meet certain standards defined by the bank, such as maintaining a minimum level of liquidity, revenues or profitability.

Negative covenants are intended to restrain the borrower from taking specific actions, such as adding more debt, making investments or replacing top management without the bank’s approval.

The SME’s lawyer will examine the loan contract look carefully at the events of default, that is, what triggers a default scenario in which the loan may have to be repaid in full. However.. these events are often loosely drafted and can be easily triggered by omission or by an external event over which the SME has no control such as a downturn in the sector or a financial crash.

Beware personal guarantees

SME stakeholders should also look out for personal guarantee requests – many an owner manager has lost their home and personal wealth by guaranteeing the loan they secure.

Borrowers should research their lender to see if they belong to The British Bankers Association and are signed up to The Lending Code.

The latter states that personal guarantees should only be called upon when all the company’s assets are exhausted, and should be limited either by value or by share of ownership. We have actually seen cases where the lender has restricted the sum they called upon in exchange for the guarantor’s cooperation in realising the company’s assets.

What does the venture capitalist require?

When it comes to equity financing, the basic questions are what the venture capitalists require in return for their investment: a majority stake? a seat on the board? a vote on the appointment/removal of directors? a particular class of shares?

Here we strongly advise SMEs not to give away control to secure funding.  

If equity is being handed over, make sure it is for cash.  Giving away equity for work (sweat equity) will inevitably cost more in the long run.  And never give away equity for a loan.  A couple of key pointers if equity is being transferred are: drip feed equity overtime to incentivise performance and include buy back options for failure to perform. SMEs should agree clear audit rights upfront with the investors and limit the role they will allow their backer within the company.

SMEs should also look out for the covenants that the venture capitalists wish them to sign. If, for example, the investors wish to introduce restrictive personnel covenants, these may simply prove unenforceable.

One advantage is that since equity finance does not appear on the balance sheet, the company may seek out loans in future – unless it is subject to a restrictive covenant.

Due diligence activities in preparation for venture capital will, however, prove expensive and this is a cost that the SME will be expected to bear.

Indeed, the costs of either debt or equity financing will be high for the SME by the time that transaction, appraisal, audit and monthly fees have been taken into account.

Key pointers

The same advice holds true for equity finance as for debt finance – SMEs should always research the source thoroughly and exhaust the friends, family and fools route first.

At the Heads of Terms stage, they should drill down into the demands being placed upon them to secure the funding, remembering that nothing is binding at this stage. In fact, SMEs should operate in the belief that everything (particularly a personal guarantee) is negotiable.

They should always watch out for the events of a default and for hidden charges mounting up.

And, of course, SMEs should take appropriate expert legal advice before it is too late and a contract is signed. Proactive legal advice is much cheaper than reactive advice to resolve a dispute.

We at The Legal Director know this area of law extremely well and can be contacted on 020 3755 5099.

Posted Thursday, October 13th, 2016 by Warren Ryland



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