Why SMEs May Prefer Debt Financing vs Equity as a Result of COVID-19

Governments across the world have tried to provide what they deem to be the best packages to protect their businesses and, in both the US and the UK, loans have been offered to small and mid-sized businesses (SMEs) to help them stay afloat. Many are experiencing dramatic drops in revenue, which are in turn causing significant operating losses and have led to layoffs, closures and the erosion of working capital, amongst other things. As a result, SMEs are being required to access capital to improve liquidity and stay in business. When given the option to access capital via an equity injection, wherein the SME is required to lose some amount of ownership to a capital provider, or to access capital via debt, there are reasons why accessing capital from debt can be more advantageous for the SME.

Below are four reasons why SMEs should consider accessing debt during this COVID-19 outbreak;

Less than favorable equity valuations.

With the anticipation that a large amount of distressed asset opportunities will be observed in Q3 and Q4 of 2020 and Q1 and Q2 of 2021, it is likely that equity investors may be looking for investments  which are significantly undervalued. As such, equity injections from private equity, venture capital and other capital partners may not be on favourable valuations to SMEs, which will otherwise detract from the desirability from accessing capital from these sources.

Ideally, equity investments should be capable of delivering accretive growth to both the party providing the capital and those receiving it. In distressed situations these metrics become skewed in favour of the party providing the capital, as substantial discounts to value often need to be observed by the capital providers in order to ensure the potential for appreciation in the equity value of the company. 

Debt is likely cheaper. 

Given that one can anticipate the cost of capital from equity to rise (due in large part to the above); it is likely that accessing capital via debt may be cheaper for many SMEs and particularly those with hard assets and previously defendable valuations. For those SMEs with historically strong earnings before interest, tax, depreciation and amortization; market share and intellectual property, for example, it may make sense to utilize debt, even with relatively high annual interest rates, to provide liquidity during the challenges we face as a result of this COVID-19 outbreak. 

Flexibility.

When considering the turmoil and future unknowns as a result of COVID-19, there is an argument to suggest that debt can provide greater flexibility to the SME when things begin to normalize and the economy starts to recover. Even with penalties for early repayment, debt can provider greater flexibility to the SME when liquidity has increased due to improvements in working capital as a result of increased sales etc. Unlike an equity injection, debt may prove to allow for a quicker path forward with less costly implications for the SME’s ownership due to the ability to repay it without long-term ownership considerations.

COVID-19 Government Aid is Cheap.

With the US Government introducing various loans as a form of economic relief for SMEs, the ability to access lending quickly and at low interest rates is appealing for SMEs. In comparison to equity injections, these loans can be obtained quickly and will likely be a first stop for any SME requiring additional capital. 

It should be noted that, although debt may be a preferable option for many SMEs during this challenging time, it may not be feasible for all. SMEs who have experienced catastrophic impacts as a result of COVID-19 may require equity as any form of a loan may not be sufficient and/or feasible to repay. 

Historically, a type of cautiousness around debt for businesses has resulted in limited options for the global SME market, but with this transformative business culture that has developed since the financial crisis of 2008, it is a valuable tool for business leaders. Embracing good debt options, particularly during this crisis period, could be vital for both survival and scale once this pandemic has passed.Fintech News

Private debt may be the best and fairest solution for many global SMEs, and in a considerable number of cases, could be more competitive than the Government support that is currently being offered. This is why it is imperative to explore all available options as a business leader, and consider debt as a competitive alternative to equity.