Debt vs Equity Financing: Capital Structure for Business Growth

Hey there Visionary Business Builders. Are you leveraging your capital structure to drive growth? Or is it holding back your business? Whether you're an entrepreneur scaling up or a seasoned business owner navigating the complex financial landscape, this channel is packed with actionable insights. Welcome to another episode of the Inner Circle Boardroom's Visionary Business Builders. A number of you have reached out regarding capital structure optimization. Therefore, in this episode, we'll be addressing your questions. When to optimize your capital structure? Key metrics every business owner should know. Real-life examples of success stories. Effective decisions to maximize returns when controlling risk exposure. Don't forget to subscribe for up-to-date video releases. You'll find us on YouTube and LinkedIn. Today, I'm back in conversation with Mike Elwood, seasoned corporate financier with over four decades money markets experience, formerly the managing director for Santander and RBS. Mike, let's start with why is capital structure optimization important and why should it matter to every CEO and business owner? Capital is the lifeblood of every business. How it uses that capital to generate value for the shareholders is what all businesses need. There are different types of capital and it's important when looking at what your objectives are, what the plan is, what the strategy is, to have a capital structure that gives you enough for growth, but in a way that doesn't place the business at too much risk. Leverage within a business on debt levels can be too much and can threaten the existence of the business, but equally, it can fuel very strong growth. Getting that balance right is really what capital optimization is all about. In your experience, how does capital structure optimization impact a company's ability to scale effectively? Let's think of an example business that is wanting to expand. It wants to build a factory, might want to take people on, new contracts, might want to invest in sales and marketing to fuel some growth. Its options are to raise additional equity from the shareholders, which has its merits, or to seek debt finance from a bank or other lending institution. Debt finance comes with obligations, it comes with the need to make interest payments, it comes with the need to make capital repayments, and it comes with controls around it in the formal governance. So all of that needs to be taken into account around what the business can currently sustain. Can the existing profitability of the business sustain the debt levels that you have in mind? If that's not likely, and the company needs to grow to make those repayments, then it's likely that some form of balance of equity and debt is the right solution rather than debt on its own. And different businesses have a different debt capacity. It depends on the length of the contract, it might be the sustainability of its cash flow, might be something new with its product lifecycle, whatever it is. The more robust those are, the higher the debt capacity, the better margins that make the higher the debt capacity, and vice versa. So kind of getting that balance right is really important. Break down the difference between debt and equity financing, and when should a CEO prioritise one over the other? Debt comes in the form of either a term loan, or in a resulting credit facility or an invoice discounting. All forms of debt all have obligations to repay interest from day one. Some of them have to repay capital from day one. Some of it can be sculpted in a way that matches the cash flows of the business. But they come with commitment. Equity, on the other hand, is an issue of shares in the business, and the cash goes in. There may be obligations for dividends, but it depends whether dividends are declared. But the real value is created by a growth in value of the company. Let's take a company that's worth £10 million today, and it raises debt to grow. If it doubles its value, if it raises £5 million of debt, and it doubles its value in the next couple of years, it's worth £20 million with five of debt, it's net £15 million. So actually, it's been a great result for the shareholders because they've created real equity value there without putting any money in. But if that debt itself causes some concerns because the business doesn't grow in the early years, they'll actually complain and place a real strain on the business. So if you put equity into it, then actually, there is no debt and it's worth £20 million. So it's doubled its value in that time. And it's a safer form, but you can leverage more by using debt. So getting the blend right, and getting the blend right is all about understanding what profit and cash flows the business can currently generate, and what it's likely to do in the next one to three years, and getting that right, not being too greedy, and balancing with additional equity. Another example where you've seen a business that successfully restructured its capital and saw measurable growth, or on the other flip side, potentially a deal breaker. I mean, when you see the debate around capital structures, it is alongside private equity. So when private equity are looking at buying a business, they're looking at the overall enterprise value of the business and its prospects for growth within its sector, alongside the ability to grow that by adding new product, going to new sectors, acquisitions, whatever it might be. And they generally will go along to the banks and see how much debt they can raise to make the acquisition, which means they have to put less equity in. And if they're then successful in growing the business, then the return on that small amount of equity will be greater. So they will kind of push the debt packages as far as they can, and they're prepared to pay more in interest payments to do that, in the knowledge that if they grow the equity value two, threefold, that's way more than paying a few percent more in interest. So they'll get that right. But again, it depends on the type of business as to how much debt they can get into it, and then how they intend to grow the business. So for instance, if you're going to grow organically, it's going to be an investment into plants and equipment, premises, people, contract, wherever it might be, then that takes a little bit longer to provide a return. They probably need to put more equity into that. If it's for acquisitions, then the acquisitions themselves come along with cash flow and the ability to raise more debt. So they can use debt to make the acquisition alongside potentially a little bit of equity in for themselves. So it's about looking at the time horizon, four, five, six years when they might want to exit. And if they can grow the earnings of a business and they can grow the multiple that they can sell the business for, that's when they can really create value for their funders and shareholders. There's two train of thoughts there. You have entrepreneurs who start businesses with a very clear, defined timeframe. And then you have entrepreneurs who grow organically because they are quite resistant to bring in debt to botch track some of their own success. They're very often emotionally attached to their businesses and as such, they don't like to give away equity, which they perceive as giving away control. And of course, you can have minority investments, but they want to retain as much of the equity as they can. So they'll use everything at their disposal to avoid being diluted, seeing that their eventual return will come from a sale of the business. So they spend all their time looking to grow it. I think it's also a bit like a wealth plan for them. So they use that as a form of income as opposed to thinking of it as a business which they could sell on and therefore probably even double what they're actually taking home today. And it does come down to legacy. It does come down to time horizon because there are businesses out there that I've seen that are where families own them. They want to retain control for a long time and they see it as an ability to derive income for the family through dividends perhaps. And that's when you can use that in a business that's been profitable, isn't particularly over leveraged. The family might want to take a dividend out. You can provide some debt for a dividend to be taken out within certain risk parameters. The business generates the cash and repays the debt that's been taken on for that dividend. And you can repeat and do it again and again and again. And if it's a business with longevity and is very sustainable, then it can be a pretty consistent form of income for a family to generate its wealth rather than having to sell it and taking the capital. So it depends on the emotional approach of a family as to whether they want to keep the business within the family or whether they're happy to exit and just take the business. The business is worth a hundred million or more, a very valuable business. And they sort of reached the point, they were brothers, sort of reached the point where they thought we want to sell the business and move on. We've run it for a long time. So they then got into the right, if we get a hundred million for the business, what do we do with the hundred million? We need to reinvest it. What do we know about what we know about Sinemus? I don't want to invest it on something I don't know about. So they came to the conclusion actually that to protect the capital, the best thing they could do was continue to run the business because that's what they know. They didn't want to have control of the family wealth across to other people. Other people might say, yes, you should diversify. I think they had other assets, they got wealth, but it kind of takes you around the cycle of if it's a business you know well, you can run it well, then actually generating dividend income out of that can be the right answer for your particular business. Just want to go on to talking a bit about navigating economic cycles. And we have had some questions around these. So I want to make sure that we address those to stand in some of the common pitfalls of debt and equity financing and when it's optimal. Debt capacity is all about the ability of the business to generate cash flow, to service interest payments and capital payments. And you want some headroom within that because there are always things that happen outside of your control that need to be addressed. So unexpected capex that you need, something around tax that you've missed, something in capital that changes. So you always need to need some headroom in. But the first thing to do is establish what cash flow the business can generate over the next number of years and then put together a debt package that probably uses 50, 60% of that and then work out what quantum that gives you. Beyond that, if you leverage a business too far, then actually you're at risk of breaching governments in a debt facility. Whilst lenders will look to be supportive of the business, they backed it after all, you are at a stage then where you're beginning to lose control of the business and in the worst circumstances can be taken away from you and restructured. So that's why it's important to get the debt component of that right. Equity on the other hand, if you're providing it, then you're still in control of your business. If you're taking in an external investor and getting the shareholder agreement situation is absolutely fundamental to making sure that your interests are aligned with the new investor and that the kind of rights and controls and monetary interests are all properly protected. But that doesn't have the same short term risk of breaching governance that a debt facility would. So that balance is absolutely critical. Are you able to share some best practices for optimising capital structures during different phases of economical cycles? I think it's understanding the cash flow of your business and that might sound a simple thing to do, but they're quite dynamic. Things change a lot and getting to the timing and the detail where working capital might be a large component is a critical part of that assessment. So you need a good finance person who is able to accurately predict what a level of trading turnover and profits will actually turn out in the form of cash, because it's cash that you need to be able to service any debt and obligations that you've got. Businesses always fail because they run out of cash. That's just the way the world works. So being really on top of what the cash flow is, what can affect it, is a critical point in being able to structure the right capital pieces for your business. What are some of the biggest mistakes you've seen companies make during periods of high interest rates? Taking on too much debt. I mean, very often people will say interest rates are high now, they can only come down and they don't. And the thing with interest rates is it begins to eat into your cash flow at a time when maybe trading is tougher, so you can't generate more in turnover, you can't generate more in profits. So the interest charge is taking more of the profits that you can generate. That's why getting that leverage level right is absolutely critical. So that's one of the issues. Some of it is around the wrong assumptions around capital expenditure and thinking, yeah, we can survive by not spending any money for the next year or two years or three years without realising that that begins to affect the attractive and the subbie business. So take something like restaurants and they don't invest in them. The restaurant itself becomes less attractive, looks a bit tired. What happens then? Well, turnover starts to drop. Chase turnover, you cut margins. Actually, all of that places pressure on the business to service the debt that you have. So actually understanding that capex is a big part of cash flow forecasting and making sure you've got enough for it, making sure you've got enough for tax payment is again, critical because any mistakes that you make there will make it much harder to service the debt obligation that you've taken on. Valuations, do you think that is something that people lose sight of? Valuations, I think we've touched on this in previous ones. Valuations are very emotional. It's like your house, you know, when product values fall, everyone's house on the street is falling apart from yours and you still hold out for what it was worth 18 months ago. Business valuations are the same and people will hang out for unrealistic levels of valuation without realizing that either the future looks more uncertain and therefore growth slows or goes backwards. And in such circumstances, your business is going to be worth less or other factors have already started to impinge on your profitability. So being realistic around the valuation of your business is really important. And the way to do that is to track what's happening in your sector. Look at the multiple that businesses are going for in your sector, understand where we are in the cycle, understand how you might be able to present your business in terms of growth. And if you're looking to sell and maximize the value, then timing of how you do that is important. I think I've said on previous ones, you know, you should be thinking two years ahead before you're selling your business to achieve the best valuation for yourself. Just what are some of the common pitfalls when approaching financial structures during business scalability? I think overestimating growth, seen a lot of, so kind of looking at debt and how it can help you grow your business against a set of very optimistic projections. And it's not wrong to have that ambition. What's wrong is to gear the business up in debt capacity alongside that optimism. Because as I've articulated earlier on, the pressure that that can put on the covenants and the performance and the cash of the business can't be too much. So, you know, have in your mind, you know, three cases. What is the best case? Because that's what you're aiming for. That's why you want to grow your business is the best case that optimizes the value of the business. And that's why you're doing it. So have that in mind. But when you're looking at how you can service the debt, have the downside case. What if things don't go to plan? What if things underperform quite a bit? Actually, what does that produce? And can I still service the debt I'm taking on for the growth? And then in the middle should be the kind of the base case that the bank will use to sense covenants around, well, somewhere between those two. This is what we think is going to happen when we put the control framework around this level. And you need to be really, really confident that you can achieve that. Are there any common pitfalls in revolving credit facilities to avoid? Yes, we view revolving credit in things that we've looked at where there have been big working capital cycles for businesses. So revolving credit is something that is committed by lenders to being available to the company. But if the company's one that's got peaks and troughs and working capital, so it can be sat on cash at a long time, but then needs to spend it all to pay supplies or whatever it might be, then the most efficient ways, rather than being able to draw revolving credit, rather than taking out a 5 million term debt and then find themselves up to a million of cash for half of the year, the revolving credit facility will work better for them in those cases. Still have a controlled framework that the bank or lenders will want to utilise, but it just allows the business to match the receipt of its cash flows against its liability commitment in a more efficient way. And so that's why we've used revolving credit. We hear a lot about hybrid financing. Mike, can you explain what it entails and why it should be a game changer for growing businesses? So I think by hybrid financing, it's kind of the use of either mezzanine within a facility, or it's the use of a unit charge to provide, as it suggests, it provides debt, mezzanine and equity all in one go. And this is looking at providing what is a debt instrument that has different characteristics. So it might be more than you would usually provide to a business on debt. And therefore, the increased risk you're taking is compensated for by, first of all, a higher interest rate. But if you think about my earlier comments, you can only go so far with that before you exhaust the cash resources of the business or the cash flow of the business. So it will have, the mezzanine will have something and will have a PIC requirement payment in kind, which means the interest accrues, but isn't necessarily paid. And it's paid when it can be paid. And there might be an equity payment, so they might take a warrant or an option in the business, which gives them a return from the increase in value in the future of the business. So the provider of a hybrid facility is getting part interest payments, it's getting deferred interest payments, and it's getting an upside when the business might be sold or refinanced sometime down the line. And all of that together will give them an IRR of something like 15-16%. Really blends together what is the cheapest form of financing, which is debt financing, with the most expensive form of financing, which is equity financing, and it blends it all together. Those businesses need really good, strong, predictable cash flows. And if they have that, and you're looking to grow it, then they can be appropriate. But again, it's for the director of that business to be really comfortable on what the projections look like and what cash generation looks like, and their ability to meet the covenants and the control How does mezzanine finance and traditional debt compare when one might be more advantageous than the other? Using debt and mezzanine, and maybe a bit of equity financing, achieves the same objective as a hybrid. The difference being that if it's hybrid, it's generally provided by one party, and therefore the documentation is a bit easier to manage. Whereas if you are doing debt, mezzanine, and equity, that could involve three parties. So three sets of lawyers working on the documentation makes it more complex, makes it a bit more difficult in restructuring bases. You've got different parties to address. Whereas if it all comes from one provider, it's a simpler process to manage. I'm not going to say it's a better process, but it's a simpler process to manage. Can you give an example of a business that's used hybrid financing model to successfully balance its risk and reward? It went wrong in the end with HBOX integrated finance, but that was a good example of, initially, I think it was aimed at a good part of the market, the mid-market, good solid businesses that didn't necessarily want to sell out to private equity, but they used company's flows to generate more in a debt package, and it was debt and mezzanine combined that allowed businesses to grow pretty quickly. A lot of house builders used it when it first came on the scenes. There are good businesses that use them, provided they've got very visible, very predictable cash flows. The HBOX integrated finance product, unfortunately, I think started to take a quantum of risk and a quantum of debt in single transactions that was probably unwise. Got caught in the whole liquidity crisis in 2008, 2009. In fact, they were a bit earlier. I think they were right at the beginning of it. But the product itself, actually, I think the product can work at the right market with the right companies, but they took it a little bit too far. But all the companies that use that are a good example of how you can fuel growth or take control of the business without diluting equity too far. Those watching that have typically used traditional financing and probably not familiar with the hybrid financing, do you want to give us a synopsis around what each of those ones do? Well, so debt financing is starting quite just adds a little bit more to it, a little bit more expensively. Hybrid financing is the two combined and takes the average pricing. So the debt component looks a bit more expensive, but the mezzanine piece is a little bit cheaper in comparison. So they're all very similar and really are worth considering if you're looking to grow your business. What you need is somebody to help you navigate the process and providers. So there's one thing understanding what the product is and navigating how that might be used in your business, whether it's safe in your business. The next piece is then working out who the providers are, whether they're the most appropriate partner for you. Because you might get a set of terms that look to be the best for your business. But actually, if you look behind the people, the behavior, the controls that they need, what they do in difficult situations, they might not be the people you want to work with. So actually blending terms, process, and people is quite important. Touch on the importance of equity financing during business transitions, such as succession planning for an exit. Do you want to talk a bit about the crucial role of equity financing in ownership transitions? Equity financing is arguably the most important piece of the capital structure. So that's the shareholders of the business who are backing a plan management strategy, whatever that might be, and funding it for what is the highest risk. In the event of failure, they're the people who get the money last. In the event of success, they're the people who take the biggest share. So actually, it's a really important piece. And again, if it's not your own equity and you're taking equity in from outsiders, then as well as the conditions of the funding, think about the fit with the people because you're going to spend a lot of time with them and it's difficult to get out of them. So spend a lot of time choosing who it is you want as an equity partner. In terms of how do you use the product, if you're using it for growth, then I think as well as finding people with good terms on the equity, think about how they're going to help you grow your business as well. So do they have knowledge of the sector? Do they have contacts in the sector? Look at their performance or their performance previously and how they helped businesses grow to success rate. So think about what else they can bring other than just the money. The money is important because that's what's going to help you get there. But if that can be accelerated through a network of contacts or a knowledge base that they have, then think about that when selecting who you want as an equity partner. Another question we had in is how do private equity and venture capital optimise their capital structure during transitions given that they work with short timeframes? Yeah, so two different offerings there. Venture capital tend not to be using third party debt in any way. So they might structure their equity into a business with some kind of low note and ordinary shared capital, but they're at an earlier stage. So generally the business doesn't have the capacity for a straightforward debt facility. Private equity, they're different. They will be looking to leverage the acquisition with debt as far as they can. So this goes back to looking at the cash flows of the business. What can it stand quite safely? And then making up the acquisition price with equity in ordinary shares. So typically you're looking at a 60% debt, 40% equity structure when buying a business, when private equity get involved. They'll be looking to push the debt as far as they safely can because that will mean when they grow the value of the business, the return on a smaller amount of equity is better than return on a larger amount of equity. So if they can keep that to a smaller number, then their returns will be better. But they have to be careful that they don't make it so small that actually the business is sadly with too much debt and equity gets wiped out in an underperformance in a difficult economic cycle. Is there anything that you would add in terms of the impact of capital structures on growth strategies, particularly during M&A and the common pitfalls when raising capital? All about understanding what the cash flows are and putting that into your debt facility, the cheaper form of capital and getting the most appropriate debt facility that you can. That's potentially it. It charges interest in the early days. You might get a capital holiday with it. You might then step up repayment over a period so that as the business grows, you can afford to pay more back and you end up with what's known as a bulk repayment at the end. So the debt facility is structured optimally to follow the growth of your business. But there will also be a level where the safety of the debt is reached and you then need to add equity to make that business acquisition. So kind of working hard on that structuring and understanding the flows of cash, the tax payments, the capex facility, whatever it might be, might even be the vendor deferred payments in there, all got to come out of the generated cash for the business. So getting that balance right, why advisors are there to help navigate that to do the financial modelling and make sure that the directors can sign off on the final structure. How do you think business owners and CEOs should be thinking about and approaching deal structuring to maximise business value whilst managing financial risk? So they've got to set out the strategy and the vision for what the business can achieve and look at the upside debt. And that's the reason you do the deal. That's why people take the funding on, is to get the business from A to B when ultimately it's worth more at B than it was at A. So they set that piece out and then you need to have a good finance team internally and use external advisors to then put together a financial model that shows how you will get from A to B and where the other tight points might be in either profit performance or cash flow generation and then how you navigate around those. So do you do something in the structuring that gives you more headroom at the pinned points of a particular model? But you have to build the model to go through that. But that should be done by advice and finance team. CEO is actually setting out what the vision is, what the objectives are for the financial model to be built. What financial metrics in your view should a CEO monitor most closely when assessing their capital structure? It's a whole suite. You can't boil it down to do one or two. Start thinking about what it is you're going to do. So if you're growing the business, then you want to know about turnover growth. So you want to know that the business is continuing to grow at the level that you forecast for the debt and the structure that you've taken on. You then need to be certain that it's doing that at the right margin so that you're not meeting your turnover at the expense of margin. So there are fairly two early indicators about are you on track or on plan. You then want to look at cash generated and actually what is the free cash generated by the business and then where it's spent. So is your capex in order? Is the debt facility working? But can it track through the components? There's probably half a dozen there that you need to be aware of to make sure that the vision you've set out over three, four, five years can be achieved and the debt and the structure can be serviced. Is there anything you tend to see that business owners or CEOs tend to miss out? They can miss capex. They can miss some of the expenses down the road. They can underestimate what they need to pay their people. Government can change national insurance contributions, for instance. That might not be in your model. That's something you've got to observe. So these are all reasons to make sure that headroom is in place. The ones that didn't have enough headroom in place to survive some of the uncertainty that might be around the corner. When does it make sense for a business to take on more risk versus de-leverage for longer term sustainability? It has to come down to the ambition of the shareholders and why they're there. So business itself, there isn't a right moment for business itself to take on more risk. You would do that because the shareholders believe they want a stronger return on the capital invested in the business. And they might say, look, we're not going to get a return there. So either we sell the business and accept that we get our capital back and it's something that hasn't worked, or we try and grow the business to get a better return on our investment. And we'll grow the business to get a greater value in the future. And therefore, it's about, right, what do we need to do that? So what's the plan? So you can't do it financially. You have to do it in what do we go for? Are we going for more market share? Are we going for new markets that we're going to go to different sectors? All of that sort of thing. You decide that's what you want to do. That then gives you a model that you need to fund. And then you look at, right, if we did all that, and what we expect happens, happens, will we have created enough value? So you have to get the order right. It has to be following a business strategy and vision and then working out, right, okay, so we're taking, this is the risk we're taking to get there. Is the result or the potential result, is that going to give us a big enough return? Practical frameworks you'd recommend from CEOs, particularly when they're assessing whether their business financial health is strong enough to support growth ambitions? I think it's good for a CEO, and he can do this in conjunction with his lenders or other shareholders, but to really take stock of where the business is and understand who its customers are now and why they would continue to buy the product or service from them in the future. Very easy to get carried away with planning for next year and we need 10% growth, but actually stand back and say, what is my business like? What is the product and services we deliver? Who do we deliver them to? What's the outlook like for that sector? How supply chain look like? What's the availability of the properly trained staff? All of those things, and just to take a moment to take stock of, is the business in good health? Do I have a good, solid platform to forecast the next one, two, three years? I think that's a really good starting point for any CEO to do annually. In PLC terms, actually, the CEO has to think about the report and accounts and what he's going to say, and that's a lot of what he's reflecting on when he does that. Well, that exercise is just as solid for private businesses for their own use. Always have this full process whereby you see it in the healthcare sector, where you'd bring in external auditors to just look at operationally how the business is run. Maybe that could be a way that CEOs could get a third party to come in and just have a non-conflicting view on business from a financial perspective as well, and operational, and therefore that might be supportive of the direction in terms of whether it's still aligned with the strategy. There's some value in that. Yeah, there is, and there's so much more data around now for businesses to use to help assess all of that. It's kind of making sure they understand the data that we've got available and use it effectively. Brilliant. Mike, thank you as always for hopping on and having this conversation with me. Folks, that's all for today's episode. If you have any questions on a capital structure optimisation that you're working on, or perhaps a deal structure, or would like some input, we'll include our email address below. Don't hesitate to reach out. We'll answer any questions that you may have. If you found this episode valuable, you're in for a right treat. We've got treasure trove of interviews with other visionary business builders, all sharing their heart and insights. Don't miss out on new releases. Go to the Inner Circle Boardroom of Visionary Business Builders. You'll find us on YouTube and LinkedIn. Hit the bell notification to stay in the loop for our next deep dive with a visionary business builder. Till next time, keep aiming high and building smart.