The Necessity of Debt

Welcome to Thriver’s short reads about investing in SME debt and how the SME debt market works. You’ll read them faster than you finish your cup of coffee.

Small business and family enterprises or SMEs represent $400 billion in debt, growing at 6% a year. There are 170,000 SMEs with revenue of at least $2 million that need money to grow further.

Relatively few business owners can sustain the capital needed for $2 million of revenue and above. If you have reached the limits of your personal balance sheet, you need to look externally. The two basic choices are debt and equity finance. According to the Productivity Commission, on 2018-2019 data, 25% of SMEs with turnover of $2-10 million applied for debt finance; yet only 6% of all SMEs sought equity finance. One can describe the preference for debt over equity as ‘the necessity of debt’.

Economic theory says that SMEs, lenders and investors will often prefer debt to equity, for a number of reasons. With debt, an SME owner retains ownership and control of their business. They are the sole beneficiary of their decisions and actions. There is no incentive misalignment between the SME and the lender. The relationship is simple: the SME borrows from and must repay the money to the lender.

In contrast, equity investment can result in serious misalignment between the parties. An investor may see their capital deployed towards objectives other than maximising profit, such as investing in growth or an owner inflating their salary. An SME owner may see attempts by investors to control decision making – along with their ownership being diluted – as being too high a price to pay. The perception of interference is a classic misalignment.

The necessity of debt has another aspect. For most SMEs, debt is more readily available on ‘reasonable’ terms than equity. Debt markets provide liquidity – the money that enables businesses to function and grow. Often, the lenders will reduce the cost of debt by over collateralising. That is, they can offer a lower price because there is lots of asset security if something goes wrong. An equity investor doesn’t have that option. Their investment is by its nature ‘at risk’ and they are incentivised to determine the ‘right’ price to pay for their investment. An equity investor’s assessment of that ‘right’ price and their resulting percentage of ownership will often be at odds with those of the SME owner.

That’s not to suggest that debt lenders are less cautious than equity investors. It is just that lenders have different mechanisms available to them. Those mechanisms, with appropriate investigation and understanding of an SME, can result in more cost-effective solutions.

This is Thriver’s space. We provide innovative, well-thought-out solutions with quick turnaround for funding needs of $250,000 to $1 million. We understand their changing requirements and work quickly to get funding in place.

Next time, we’ll look at the benefit of debt.