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.
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.
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 Friday, October 14th, 2016 by Warren RylandTweet
Other Articles In This Category
- Planning an Exit Strategy to sell your business?
The Legal Director is proud to be co-sponsor of the latest Informed Funding workshop, where you'll be able to discuss with experts and other business owners... read more
5th of June 2018 by Warren Ryland
- Is your business facilitating tax evasion?
Is your business facilitating tax evasion? Put like that, most of us would automatically answer ‘no’. But let’s re-phrase the question. Does your... read more
8th of May 2018 by Warren Ryland
- IR35 and the private sector: are changes on the way?
As the government considers extending to the private sector its public sector reforms of the rules relating to the engagement of contractors through so-called... read more
22nd of March 2018 by Warren Ryland
- GDPR: 3 practical questions facing businesses like yours
In just a few months—on May 25th—compliance with the General Data Protection Regulation (GDPR) becomes mandatory. The biggest change to data protection... read more
1st of March 2018 by Warren Ryland
- I'd like to work from home, says an employee. Now what?
Conversations about employees working from home were once very short. In those rare instances where employees did venture to enquire about the possibility, the... read more
8th of January 2018 by Warren Ryland
- Is a domain squatter set to steal your brand?
It’s fair to say that many businesses are unprepared for the new .uk Internet domain - which is unfortunate, as from June 2019, they could find that their... read more
5th of December 2017 by Warren Ryland
- Did you negotiate your last loan agreement - or just sign on the dotted line?
For businesses wanting to grow or invest, external finance can be an attractive option: access to the funds that they need, without equity dilution or... read more
2nd of November 2017 by Warren Ryland
- Protecting the value of your newly-acquired businesses can be a challenge
Buying a business is exhilarating. Hard work, to be sure - but undeniably exciting, and with a rich sense of the opportunities that lie ahead. So perhaps... read more
2nd of October 2017 by Warren Ryland
- GDPR. The clock is ticking: a tough new take on data protection is fast approaching
With effect from 25 May 2018—in other words, less than a year away—your business is exposed to a new regulatory regime backed by hefty fines. And by... read more
6th of September 2017 by Warren Ryland
- Persons of Significant Control: important changes to reporting requirements
It’s barely a year since the introduction of the PSC regime - and already, the compliance requirement has been tightened. And at a time when many businesses... read more
23rd of June 2017 by Warren Ryland
- Avoiding conflict when forming a business: probing questions for potential partners
Every year, several hundred thousand new businesses are created. In 2015, according to the Office for National Statistics, the total was 383,000—the highest... read more
28th of April 2017 by Warren Ryland
- Is your business at risk from the Uber decision? Why your self-employed contractors could really be employees
Fuelled by companies such as ride-hailing business Uber and personal courier firm Deliveroo, the so-called ‘gig economy’ is on the rise. So much so,... read more
12th of January 2017 by Warren Ryland
- The Legal Director - Commended for Innovation in the FT Innovative European Lawyers awards
Law firm The Legal Director (TLD) has been commended in the FT Innovative European Lawyers awards, which were announced at the beginning of this month. TLD ranked... read more
28th of October 2016 by Warren Ryland
- The deceptive complexity of the Modern Slavery Act
At the end of July, Prime Minister Theresa May launched a cabinet-level government taskforce to eradicate modern slavery in the UK. It was, she said, “one of... read more
31st of August 2016 by Warren Ryland
- How our clients will benefit from the Bar Council's escrow account
Outside the narrow realms of consumer technology, there’s often an inevitable trade-off between cost and quality. In other words, you can have something at... read more
7th of July 2016 by Warren Ryland
- As the net starts to close, the Bribery Act prosecutions begin
As we have written before, the Bribery Act 2010 is a law with undoubted teeth. Fines are potentially unlimited, and custodial sentences can be up to ten... read more
1st of May 2016 by Warren Ryland
- New rules on shareholder identification are now in force
New rules on shareholder identification are now in force - and yet many businesses aren’t aware of them. Does your business have corporate or nominee... read more
12th of April 2016 by Warren Ryland
- First SRA-regulated law firm signs up to Bar Council's escrow account
PRESS RELEASE: The Legal Director has become the first law firm regulated by the Solicitors Regulation Authority (SRA) to sign up to the Bar Council’s... read more
31st of March 2016 by Warren Ryland
- Trade marks: the 3 biggest mistakes to avoid
Wander around a supermarket, or browse the advertisements in newspapers and magazines, and you’ll see trade marks everywhere. And it’s likely, too, that... read more
29th of February 2016 by Warren Ryland
- Avoiding flexible working's hidden pitfalls
You don’t have to look too far to see that traditional modes of employment are increasingly giving way to more flexible working arrangements. Returnee... read more
9th of November 2015 by Warren Ryland
- Are you paying your workers the right amount of holiday pay?
A recent ruling by an Employment Appeal Tribunal is set to cause many businesses a headache. Quite an expensive headache, at that. Simply put, it means that... read more
15th of July 2015 by Warren Ryland
- The Bribery Act 2010: are you running a risk of breaking the law?
To see the difficulties that businesses can get into through bribery - or even allegations of bribery - look no further than the reputational damage suffered... read more
11th of June 2015 by Warren Ryland
- It's official: "Lawyers are not cost-effective"
Imagine, for a moment, that when faced with a serious illness, significant numbers of people took no action. And of those who did take action, around... read more
20th of January 2015 by Warren Ryland
- Could a Shareholder Agreement save your business?
Here at The Legal Director, we’ve recently come across a business where the two co-founders have fallen out -- one is now leaving, in order to set up on his... read more
1st of December 2014 by Warren Ryland
- The high-fee culture that's hobbling British business
Another week, and yet another critical item in the press on the cost of obtaining corporate legal advice. And to be sure, it’s certainly a fairly open goal at... read more
11th of November 2014 by Warren Ryland
- Is crowdfunding the answer to your business's financing challenge?
As the credit crunch and ensuing recession of 2008 began to bite, lending to businesses dried up. To their shock, even long-established, profitable businesses... read more
2nd of September 2014 by Warren Ryland
- Complying with the Data Protection Act: 3 business bear-traps awaiting the unwary
Visit the website of the Information Commissioner’s Office, and there’s an interesting section entitled ‘Enforcement’. In it, the... read more
1st of September 2014 by Warren Ryland
- What might a Legal Audit reveal about your business?
When we start working with a business we assess their existing legal arrangements to determine how these can be improved and aligned with commercial objectives. We... read more
9th of July 2014 by Warren Ryland