Once a sustainable growth strategy is adopted and the quantum of financing is determined, business owners are usually confronted by the next question: do I use debt or equity?
Debt – money lent to you by the bank or some other source on terms – is typically cheaper given that the interest you pay on the debt is tax deductible. While this may make it sound initially more attractive, the downside is that typically the lender requires repayment whether you make a profit or not, and generally will secure their debt against your private resources. Debt arrangements may be somewhat inflexible so the key to this form of financing is obtaining the right price over the right term and with a repayment arrangement that meets the cash inflows expected from the growth strategy.
The cost of equity, on the other hand, lies in you giving up an ownership interest in your business and is represented by a loss of future dividends and capital gains. If the business does not make a profit then there is no immediate cost to the equity financier making it somewhat more flexible than debt. The lesser immediate cost of equity makes it appear more attractive than debt, however, in my experience very few equity arrangements between unrelated parties succeed in the medium- to long-term, typically due to differing ambitions and aspirations and a lack of shared goals and visions.
In Australia equity financing sources are rare for small- and medium-sized businesses, and where they do occur, they will generally be among friends or family. Therefore, your most obvious source of finance will be debt and it will most likely be your bank.
Your rewards from future growth will come from ensuring that the arrangements you negotiate with your bank are at a reasonable cost and repayments are synchronised with the cash flows from future new clients.
