Why Most SMEs Choose Debt Over Equity Financing

Why Most SMEs Choose Debt Over Equity Financing

You are a business owner needing financing to expand your business. You have set plans to visit banks for a possible debt financing.  However, you still have doubts if applying for a SME loan in Singapore is the best financing option.  While you have heard about equity financing, you aren’t sure if it is any better compared with taking out a bank loan.

To quell your doubts and help you decide if debt financing is really “the one”, here are 7 reasons why most small businesses usually choose debt over equity financing.

No dilution of ownership

Equity financing is a way of raising capital for your business.  It allows you to sell a fraction of your company to investors.  In exchange for the funds they’ve infused in your business, investors become co-owners.  The extent of co-ownership varies, depending on how much equity they’ve poured into the business.  The ownership and control you are relinquishing can be minimal, say 10% or, a hefty 70%, relegating your ownership to that of a minority.

With loan financing, you aren’t giving anyone control over your business.  You remain as the owner along with your business partners if any.  You aren’t diluting your stake in the business because there’s no new investor coming into the picture.  You have a loan and you just have to pay it back with interest, based on the terms of the loan agreement. However, be prepared to offer some collateral.  Generally, some banks will ask for an acceptable property, equipment, or company receivables as assurance in event of default. For SME financing, many banks do offer unsecured financing facilities as well such as business term loans.

Shorter waiting time

The time it takes for a bank loan to get approved will usually take two weeks to a month, depending, of course, on how well you have complied with all the bank requirements, the loan amount, and other considerations.

Obtaining funds through equity financing does take longer.  Closing a deal with investors may take months, not to mention the time spent on pitching a business presentation to potential investors.  These could rob you of your precious time allotted for taking care of the business.

You run the business as you please

In equity financing, new investors will have a say on how to run the business and at the same time share in its earnings.  Business decisions regarding expansion, outsourcing, financing, and other projects will now be subject to the approval of everyone who has a stake in the business and that includes the new investors.  If there’s a new business idea you wish to test or adopt, you’ll might have to obtain the consensus of everyone who has an interest in the business.

Meanwhile, obtaining financing through debt tells a different story.  Creditors are not in a position to decide which growth directions your company would be taking.  They won’t be sticking a finger in the pie.  Their biggest concern actually is to be able to collect from you the money they have lent you, including income in the form of interest.

They expect you to pay your loan amortizations in full and without delay.  To ensure that lenders get back their investment including interest, they will, from time to time, monitor the “health” of your business. Your cash flow statements and other financial reports will help reveal if your business is in the pink of health or showing signs of deterioration.  So be prepared to present cash flow and financial statements on an annual basis, especially so if you have an revolving credit facility with your bankers.

Disregards the need for reporting

As a borrower, you aren’t obliged to report to anyone about the status of your business.  You just have to follow the loan covenants, which include payment of monthly dues as scheduled, and submission of financial statements, if necessary.

In equity financing, you are obliged to report to your investors.  You will have to prepare regular reports to serve as an update on business operations as well as plans and forecasts.  Some investors impose a monthly investors’ meeting to keep them posted on activities and issues that have an impact on their investment, especially the business valuation of the company.

Wider accessibility

Banks and other financiers accommodate a wider range of businesses. In terms of size, there’s opportunity for both small and large-scale business owners to avail of a loan.  Investors, on the other hand, prefer to invest in companies with high scale-ability and potential for explosive growth. Therefore, small traditional brick and mortar businesses usually don’t stand a chance with such investors despite proven profitability and stability.

There are also many banks active in the SME banking space in Singapore, especially the 3 local banking giants. As an SME, it’s easier to access bank facilities such as UOB business loan through the banks’ extensive consumer touch points then to locate a VC to pitch for funding.

Although banks with retail presence are easily accessible, there’s no guarantee of course all banks will approve your SME loan application. Therefore, you need to know how to improve chances of loan approval.

Positive impact on credit history

Obtaining debts and paying loan amortizations promptly creates a positive impact on your image as a borrower.  Eventually, a clean history of debt repayment will reflect on your overall credit rating.

Maintaining a satisfactory payment record for each debt that you’ve obtained will also boost your relationship with your creditor.  Banks will trust you more and this alone could open doors to more opportunities and conveniences like additional financing, faster loan approvals, and better loan terms.

Carries a tax deductible advantage

All business loan interest rate paid is tax deductible and can be treated as an expense on your Profit & Loss.  So, whether you obtained a revolving credit line, a medium or long-term loan, or a bridge financing, it won’t matter for as long as you used the loan proceeds to fund a business activity.  For example, if you borrowed funds to purchase a company vehicle, settle a month’s payroll, or upgrade your accounting system, you may avail of tax deductions on the interest expense.

The interest you’ve paid will form part of your tax deductible business expenses which you’ll deduct from your company’s earnings before tax.  By doing so, you reduce the amount of income that is subject to tax, eventually realizing some savings for the business.

This tax deductibility angle also translates to a lower interest rate and you should factor in this feature when making financial projections for your business.   For instance, when forecasting interest expense for a loan obtained at 12% p.a., it is appropriate to calculate interest based on a 10% instead of 12% p.a. rate.  Assuming a 17% business tax, the 10% after-tax interest rate is computed as follows: 12% * (1 – 0.17).

Equity financing doesn’t offer a similar tax benefit.  While there are no amortizations to settle monthly, this type of financing requires you to put up funds at the onset to pay for services rendered by lawyers, accountants, financial advisers, and other professionals who will be assisting you during funding rounds.  Additionally, in the course of looking for potential investors, you’ll certainly spend on travel and occasionally, on entertainment.

The final verdict

Despite the apparent advantages offered by a debt facility versus equity financing, the final decision rests in your hands.  As a business owner and the captain of your ship, you are in the best position to decide if sailing towards debt financing is indeed the best choice.