Loans vs equity finance

It is a very rare SME which has a war chest for acquisitions. Most of us have to go begging for the money to fund an acquisition. While banks are somewhat sympathetic to financing growth through acquisitions, they are still risk adverse and still want to see their risks mitigated by asset coverage.

On the other hand, equity is a possibility but it does dilute the existing shareholders. Given that the future is never guaranteed, finding a solution to the finance problem takes some work.

The problem with the choice between equity and debt financing is that it represents two risk extremes. On the one hand, the bank needs assurance the debt can be serviced with interest payments and they want to know they will get their money back from capital repayments. On the other hand, when equity is used to finance an acquisition, the business has no contractual obligation to pay dividends and investors take the risk they might lose all their investment.

While many people complain that the banks are inflexible and unreasonable in their lending policies, we need to take into account their risks. A bank which is trading on a 2% differential between the costs of borrowing and lending has to do 50 times more lending to make up for a bad loan.

You would have to be a brave bank manager to extend a loan without adequate cover on both the interest payments and the capital repayments. So bank finance has limited application in the acquisitions space.

When you go to the other extreme and raise equity you face another set of hurdles. If you are seeking venture capital or angel finance, you have about one in 10,000 chance of raising the funds. Even so, you will need to have an exit strategy for the investors, which normally means a plan to sell the business. Not quite what you wanted when you are busy growing through acquisition but how else does an investor in a private company get their investment back?

An initial public offering is a possibility but very few ever make it. Even if you can raise the money from private investors, you still have to convince your existing shareholders they will be better off with a smaller share of the business. Since most private investors prefer preference shares, they also have to agree to second place.

Looks a bit like somewhere between a rock and a hard place. However, debt and equity can work in some situations. A business which, after the acquisition, is a cash cow, should be able to find a willing lender. A high growth potential business which has a strong exit possibility will have few problems raising equity. However, most businesses are going to struggle to find external debt or equity to fund an acquisition.

What this means is that the acquirer needs to build a war chest as a buffer for their acquisition strategy or find acquisitions which can fully or partly pay for themselves.

Tom McKaskill is a successful global serial entrepreneur, educator and author who is a world acknowledged authority on exit strategies and the former Richard Pratt Professor of Entrepreneurship, Australian Graduate School of Entrepreneurship, Swinburne University of Technology, Melbourne, Australia.