Why Deciding Between Debt and Equity Isn’t Always a Binary Choice

Broadly speaking, alternative finance platforms fall into two camps – namely, those that offer a variation on the equity crowdfunding theme and those facilitating debt funding. And for a business with little experience of either borrowing large sums of money or selling shares, the first step on the road to raising finance is to understand how and why the expectations of lenders and equity investors differ.

But the choice between debt and equity funding isn’t necessarily a binary one. There will be times when a business will benefit from blending debt and equity in support of a particular growth strategy, and there is real scope for this kind of collaboration between lending and equity investment platforms.

Horses for Courses

Debt finance – either in the form of a loan or overdraft – remains the most common way for small and medium sized companies to raise capital. Until relatively recently, the first port of call was usually one of the major High Street lenders, but the big four (incumbent) banks no longer represent the only game in town. Today, businesses are increasingly looking at platforms that bring together companies in need of capital with individuals who are prepared to group together and lend the necessary funds.

This group of platforms is not homogeneous. Some firms position themselves as peer-to-peer lending services. Others – such as The Route –Finance’s Private Debt Platform (PDP) – tap into pre-mandated funds from a group of high net worth individuals, overseen by the investment expertise of an arranger firm. This category can be characterised as ‘Sophisticated Investor to Business Lending’.

Meanwhile equity crowdfunding platforms offer individuals an opportunity to buy shares in businesses rather than lend to them. From the supply side of the equation, the main difference is that equity investors achieve returns by backing companies with the potential to grow rapidly and significantly, enabling shares to be sold at a profit on exit.

Lenders, on the other hand, are not interested in growth per se. Their main interest is achieving a return via the repayment of the original sum plus interest. Their concern, then, is that borrowers will be able to honour repayment schedules.

The differences generally define a company’s choice of platform when seeking financing. For instance, a company may well choose equity crowdfunding because it is seeking the advocacy of a community of investors who will promote the product and thus drive growth. Depending on the platform there may (in addition to the ‘crowd’) also be angel/sophisticated investors on board who will provide the lion’s share of the funding and provide practical help to support the growth strategy. Equity funding means the business can avoid the cost and commitment of regular debt repayments. However, ownership is diluted.

Another business might choose debt precisely because there is no dilution of ownership. Assuming that the repayments are manageable, this is seen by many as a plus, not least because the lenders will not have an impact on how the business is run.

Thus equity finance is often most suited to those who are seeking “more than money”. Debt is often useful for those wanting to raise sums more quickly, and who want to retain control.

Blended Solutions

Those are the broad brushstrokes. In reality, most equity funded businesses also borrow. A business that is funding a growth strategy via an equity investment – possibly with further funding rounds ahead – may in the shorter term need cash that could be better provided by a loan. There will be no further dilution of ownership, nor any need to pitch to new investors.

Furthermore, some deals require an equity raise to allow enough financial backing for a loan. Blended funding solutions are ideally suited to handle complex requirements such as this. Clearly there is real potential within the Alternative Finance marketplace for more widespread collaboration between equity and debt platforms in order to provide SMEs with a full range of investment opportunities – and to provide the same to investors.

This is something that The Route – Finance actively endorses. For instance, we recently entered into a partnership with GrowthDeck, a platform offering access to tax efficient equity investment opportunities (under the Enterprise Investment Scheme).

Debt and equity platforms do not operate in isolation. In the evolving alternative finance marketplace, SMEs may increasingly look to more than one type of platform or to providers offering blended solutions. This may well fuel a trend towards greater collaboration within the alternative finance industry.

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