It may seem counter-intuitive but, in a successful business, external equity is likely to be the most expensive source of finance. It will ultimately create value for the investor far in excess of that available from deposits or similar investments and will deprive the founder of this value. From the founder’s perspective, this may represent a significant and unwelcome opportunity cost.
In addition, using equity as a sole means of funding may reduce risk but it will also reduce returns. Take the example of an investor who buys for £100 and sells for £150 – a good return of 50 per cent.
Now consider the same situation, but imagine that £75 of the investor’s original investment is borrowed, leaving only £25 as the equity investment.
Ignoring the interest cost on the borrowing which, admittedly, is an over-simplistic approach, the equity of £25 becomes equity of £75 (i.e. £150 – £75). In this case the investor’s equity return rises to 200 per cent, a far more satisfying result.
This is known as the gearing or leverage effect, where non-equity funding can be used to boost equity returns.
In practice, lenders will not make unlimited loans, so the ability to gear the equity with borrowings will be dictated by market conditions and the assets or cash flows available to secure or service them. In addition, businesses that are highly geared (i.e. those with large borrowings in relation to their equity) are more likely to face difficulties in the event of a slowdown in demand or an unexpected loss.
As always, it’s a question of balance. The equity, which is the fixed capital of the business, needs to be sufficient to support the business after all other factors have been taken into account, with sufficient headroom to weather unexpected storms, should these occur.
One well-established principle is that a business should not borrow short to invest long – for example, the use of an overdraft facility that is repayable on demand to finance property or equipment that will be used by a business over many years. If the overdraft is called in, it may be difficult to realise the assets or secure alternative finance, potentially causing the business to commit the ultimate sin – running out of cash.
“Trying to fund growth in the long term using short-term finance is not going to work,” says David Molian of Cranfield School of Management. “Historically too many businesses have relied on short-term debt funding, principally overdraft arrangements from their bank, which are liable to be vulnerable in recessionary periods.”
Guy Rigby is head of entrepreneurs at Smith & Williamson.
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