SME Debt or equity finance?

Many forms of finance can be relevant for SMEs. In the broadest terms, SMEs can access two key sources of business finance: debt or equity.

Debt finance requires a steady income stream to meet interest payments, and often requires “collateral” to be provided, against which the loan is secured. Providers of debt financing face a risk that borrowers will not pay them back in full. If borrowers do pay them back in full, they receive a fixed return as agreed at the outset of the loan, with no further upside from outperformance. Providers of debt finance are therefore only willing to bear a certain level of risk when financing businesses.

Equity finance does not demand the meeting of regular interest repayments. Equity investors are instead exposed to potential open-ended capital growth (i.e. they have unlimited upside potential, unlike a debt financer), but may equally lose some, or all, of their investment. Equity finance is therefore better suited to higher risk situations.

Businesses with limited certainty over future cashflow or short or non-existent track-records of delivering profits typically carry more risk (particularly if they have no assets to offer as security) and therefore are less suited to high levels of debt financing. However, even businesses that have a good track record may not be as suited to debt finance as they may think.

For example, in the run-up to the recent financial crisis, rising property prices were used to justify high levels of debt where an injection of equity would often have been more appropriate. The collapse of property values has wiped out much of the equity that was on SME balance sheets pre crisis. Many SMEs who borrowed against properties valued at the peak of the market have found themselves with loans that they are struggling to refinance, as the value of the property has decreased so much. Banks are no longer prepared to finance at high Loan-To-Value ratios, and expectations of SMEs therefore need to be re-set.

Working capital provides another example. Working capital is defined as equity used to finance the operational needs of the business. The level of working capital that a firm holds is one of the most important strategic decisions that it has to make. SME owners that invest equity into their businesses to cover seasonal peaks and troughs can be more confident that the business will survive, as the business will not have any problems with liquidity. However, this safety comes at a cost: short term borrowing would normally be cheaper than the “cost” of equity to fund the troughs.

Banks looking to lend prudently, as well as SME owners looking to borrow prudently, should do so with a full understanding of the risks and trade-offs such as those outlined above. This requires a higher quality dialogue between the lender and borrower than that which has been the norm in the market to date.

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