Want to buy up a rival but not sure whether to use debt or equity to finance the deal? Here's why debt wins, hands down.

1. It’s cheaper. While debt may cost you less than ten per cent, equity can cost more than 30 per cent depending on how the investment structure works. At the same time, debt requires regular repayments, which a new business may find tough in its early years.

2. There are tax benefits. So long as the loan is taken out for the purposes of trade, such as buying fixed assets, you’ll get tax relief on the interest payable on the loan. If the loan is to buy shares, the relief is more restricted. Shareholders who borrow to lend to the company can obtain tax relief on the interest, too.

3. You retain ownership and control. Equity investment means handing over a stake in your business and a new director on your board. Managing that relationship could be a headache. Then again, the director could bring valuable business experience and contacts, which could be very helpful to a young business.

4. Debt can be more flexible than equity in at least two ways; you can potentially move from one financier to another and you can come back for further loans (subject, of course, to bank conditions and security requirements).

Beware: unsecured debt is harder to find, with a couple of banks retreating from this market for the time being. If you are with a bank where capital is restricted and you want to press ahead with acquisitions, you might need to consider a change of bank.

If can find a new provider offering unsecured debt, it will more expensive than it was a few months ago and the approval process has become noticeably longer and more stringent.

Make a persuasive business case. Banks will be looking for businesses that can demonstrate stability and relative certainty of cash flow and profits. Good profits but a lumpy and unpredictable trading cycle may have been acceptable in the past – but not anymore.

Remember: tighter covenant structures will be in place. If they’re breached, you’ll face higher borrowing costs or, at the very worst, administration.

There are other ways to finance your business, such as vendor loans or deferred consideration. Despite the headlines of economic doom and gloom, money is still available for the right deal.

The flipside of the tighter market is that vendors are adjusting their outlook and valuations. So even though the supply of money is more constricted and costly, the assets being purchased are better value. There is still just as much opportunity to do deals.

Jeremy Rayment is a director at Menzies Corporate Finance. He can be contacted at jrayment@menzies.co.uk

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