Debt vs Equity
How should the company capital be structured? Does it really make a difference how one decides to finance a company? The importance of such questions is primarily seen when analysing the intended company growth.
The globalisation of companies has shifted our attention to the structures being adopted by companies beyond our Islands. While not necessarily a prominent feature in Maltese companies, many foreign entities are structured through a mixture of equity/shares and debt financing. At the outset, one must note that the type of capital structure being adopted will influence management decisions. The capital structure creates parameters which management must adhere to.
A company may therefore have both equity and debt capital, which together make up the overall capital structure. The board of directors must find this ‘balance’ between debt and equity that will ultimately lead the company to achieve its objectives. One must obviously keep in mind that there is no ‘one-size-fits-all’ structure as all industries and markets have different needs and growth rates. It is for this reason that a knowledgeable and experienced board of directors must carefully identify the best capital balance for the company to reach its objectives.
Another factor that must be given due consideration is the minimum capital requirements rule. In Malta, this requirement is quite a low threshold, which does not create a barrier to entry for any company. In other jurisdictions, however, this requirement may be much higher and thereby resulting in a significant barrier for small companies.
Furthermore, the structure adopted by a company influences the company’s financial risk because, for example, more fixed-cost financing (i.e. debt) will in turn increase the number of claims on the company’s balance sheet and thus creating a greater financial risk. Directors must keep all this in mind when deciding whether to opt for financing through debt or by issuing further shares. All these decisions will ultimately have an impact on the management of the company. Increased debt means increased financial risk, however, the issuing of new shares for the purposes of growth will potentially mean less ownership in the company.
One must also keep in mind that potential investors look at the financial health and foreseen growth of the company before taking a decision. Achieving the right balance in the capital structure should not be overlooked or taken lightly. It is also vital to understand certain key features of equity and debt.
With regards to equity, a notable feature is that it does not need to be paid back outright, but rather represents a claim on future earnings. There are no mandatory fixed payments and no maturity date. It does however entail ownership and control over the business. Lastly, it provides for greater operational flexibility, but holders do then expect a higher rate of return on their investment.
On the other hand, shifting to debt, interest payments and fixed payment schedules are a central characteristic, which pressures directors into operating in a manner which does not create risk of defaulting on such payments. No ownerships rights are vested with debt holders and can be a quick way to raise finance to reach certain growth targets. However, it has become increasingly common for ‘financial covenants’ to be attached. These covenants have different forms, yet all place several restrictions on the company, which ultimately reduces the company’s operational flexibility.
Deciding whether to opt for debt or equity financing to increase company growth may not always come down to the directors’ preference but will rather depend on the respective industry and market. In internet and knowledge-based companies, directors tend to rely on equity financing for the simple reason that these companies lack collateral for debt financing. Instead, they opt for equity financing, resulting in a ‘loss’ of ownership and decreasing the overall influence within the company. Contrarily, it provides greater operational flexibility due to the lack of financial covenants and restrictions commonly found within debt financing.
Moreover, management style is also a key factor in decisions on financing. While debt financing can ramp up growth at a much faster pace without the direct loss of ownership, a conservative management is less inclined to this form of financing due to the increased number of claims.
Company growth is ultimately an objective for all companies. But how does one actually achieve growth? There is no one answer. It is very much a subjective analysis dependent on the management style, the company objectives, and the respective industry. It is undoubtedly a double-edged sword for both forms of capital financing. While debt increases growth over a short period of time without loss of ownership, the financial covenants that accompany them can lead to a decreased level of operational flexibility. Alternatively, equity places less restrictions on operations, however, it leads to a direct loss of ownership. Ultimately, all these points must be considered when analysing the current structure and objective of the company and the financial means of how it is going to achieve the intended growth.