At first glance, raising equity financing for a business or a business expansion has one clear benefit: the business owner is not obliged to pay the money, which is a good option when cash flow in the business is too low to cover a regular loan. This is mostly the case in a start-up or an expansion phase. But not having to repay the money does not mean that there are no pitfalls involved.
The best financing option depends on the type of business and its state of development. Start-ups and small businesses might not have many choices other than to look for seed capital (i.e. equity), because a bank loan would require regular repayments. Borrowing funds from non-commercial sources such as friends, family or supporters could also work, especially if you agree to pay back the interest regularly while deferring payment on the principal amount. Banks would offer such schemes too, but they usually want an asset to back the loan, such as property or any other collateral.
The appetite for loans is back in the UAE. A recent report by Emirates NBD has found that borrowing for businesses is strengthening. It said that lending to the construction sector jumped significantly, as well as loans for retail and personal loans for business purposes.
Tim Fox, Chief Economist, Emirates NBD, says in the report, “The fact that individuals are taking loans for business purposes and that non-resident companies are increasing their deposits in the UAE suggest that firms are optimistic about growth in the UAE, and may be looking to increase investment in the future.”
Debt financing scenario
Let’s say a medium-sized travel agency wants to expand and open new branches. It needs money to lease and equip shops, advertise, print leaflets, hire new people and develop new itineraries. It decides to go for a bank loan on the grounds of a well-designed business plan and the fact that the tourism industry in the country has shining prospects, which is also the opinion of the bank.
There is enough cash flow to repay the loan regularly out of the running business, and the agency owners, two brothers, have full control of their own destiny regarding their business and do not need to listen to any investors holding a stake.
The current interest rates are quite low, which make the loan affordable, and if there was income tax in the UAE, the rates would be tax-deductible. With regular repayments, the travel agency can also build a good credit record.
As collateral, the bank is fine with some business assets. And when the loan is eventually settled, the business relationship with the bank ends.
However, the agency owners will have to show strong discipline in repaying the loan when they face cash flow problems during lull periods, as the monthly instalments normally won’t change. The growth potential of the business is also affected by the relatively high costs of the total loan. If sales dip, the owners of the agency might even have to repay from their private funds, depending on the type of the enterprise.
Equity financing
Equity financing comes into play when a business cannot afford a loan and seeks less risk, as investors understand that they won’t get their money back should the business fail. In short, the business risk is (partly) transferred to the equity investors, but this comes with a number of obligations for the business owner. Let’s take a start-up company that wants to participate in Dubai’s smart city vision by developing intelligent water meters to be deployed within a future smart grid. There is just an idea and a vague business plan that wouldn’t convince a bank’s credit manager. But the start-up is able to find an investors’ network that is excited and believes in Dubai’s smart city vision and decides to take a stake in the new company. At that point, the start-up gets enough cash in hand to hire experts and start developing its product.
It is clear for the equity holders that they have entered a long-term relationship and don’t expect fast payouts. However, most of them want to get involved in the business as they are holding part of the ownership and also want to make sure that the capital is used in a productive way and expect to be informed regularly about all significant developments. In worst case, they could even block business decisions.
An equity financing partnership should also have clear agreements on the point of time when investors can opt out and what the expected profit rate is, which can possibly be more than the entire cost of a loan, as an investor is taking a higher risk than a bank.
Mohammad Al Shroogi, President of Gulf Business at Bahrain’s Investcorp, says, “Return on investments on private equity deals in the Middle East is between 23 and 27 per cent. Higher risks bring higher returns.”
It is also worth mentioning that finding investors takes time and effort and there is a lot of paperwork and legal requirements involved. Furthermore, equity financing is not yet quite developed in the UAE, which is another drawback.
“Equity financing is a viable option for SME financing in the region, but the UAE lags behind developed countries in deploying this means of finance. The market for financing a ticket size of Dh5 million or less for a start-up is almost non-existent here,” said Alexandar Williams, Director of Strategy and Policy at Dubai SME, at the SME World Summit in Dubai in March.
“There is, however, a great opportunity for this financing method to develop into a mainstay of funding as the UAE economy moves towards higher value-added activities and further improves its business and equity investment laws.”
In a nutshell, most companies use a mix of debt and equity financing, depending on the nature and status of the business. This is leveraging the disadvantages of both financing methods, but also compounding the upsides.
Business owners will have to think carefully about the right debt-to-equity ratio on the balance sheet, which describes how much debt is in the company in relation to its equity. It again depends on the type of company, but debt should normally not be more than 40-50 per cent of equity to keep the balances and growth perspectives healthy.
