In the current environment of rising interest rates, it might be tempting to assume equity is the better choice, but many considerations say otherwise.
If you're seeking capital to grow or expand your independent insurance agency, you are probably debating whether you should take on debt or raise equity investment. In the current environment of rising interest rates, it might be tempting to assume equity is the better choice, but many considerations say otherwise.
Debt and equity are ways of generating capital for business needs. You may need extra cash to purchase another agent's book of business, make a capital investment or to take on additional producers. Capital may also be needed to buy into an agency as part of a succession plan.
If you take out a loan—borrow money from a lender or individual—you are taking on debt. You and the lender work out the terms of the loan, such as interest rate, repayment period and collateral needed to back the loan in case you cannot repay it.
In comparison, cash raised through equity investment means you are offering a share of the ownership of your agency to an outside individual or group in exchange for their money. These investors have a say in how your business is run and their involvement continues for as long as they maintain an ownership position.
When comparing both types of capital, debt via a lender is often cheaper than equity, especially if your agency is profitable. The interest paid on the loan is finite and once the loan is repaid, the lender has no other claim on your company. Equity investors, however, continue to take a share of the profits of the business for as long as they maintain ownership. For a business that is strong and continually making a profit, the long-term cost of equity financing could be much higher than the interest paid on a loan of a similar size.
Here are some pros and cons to consider for each approach:
- Depending on the deal structure, dividend payments may not be required.
- Investors can be a source of industry expertise.
- Repayment of the investment is not required if the business fails.
- Leverage is reduced, which improves the financial health of your business.
- The business owner gives up independence and may have to report to someone.
- Time and energy are required to court investors.
- Management decision-making is slowed by the need to consult with investors.
- Future loans may be subject to approval by investors.
- The owner retains control of the company.
- Fixed repayment schedule creates predictability.
- The relationship with the lender can help with future acquisitions.
- Interest is tax deductible.
- Repayment options can be flexible.
- Debt must be repaid.
- Interest rates are rising.
- Business owners could have difficulty obtaining a loan, especially if the lender is unfamiliar with the industry.
- Borrowing increases debt-to-equity ratios.
Additional advantages of debt financing over equity investment include both flexibility and control of your agency over time. Also, debt can be structured in a wide variety of ways to meet the needs of both the purchaser and the seller. In some cases, the seller needs liquidity and wants to sell their agency but would like to keep working. Using debt financing, the buyer can pay off the seller in a lump sum or installments while retaining the seller on staff and having the advantage of their expertise.
When it comes to maintaining control of your agency, most private equity investors are looking for a return on their investment in five to seven years. That means they could sell their stake in your business to recoup their investment, whether you're ready to do so or not. With debt financing, you are in control of your business—not only in the present, but in the future as well.
Whether to use debt or equity financing depends in large part on the cost of equity versus the cost of debt and the level of control you are willing to cede to another party. A mergers & acquisitions advisor can help navigate the complexities of these significant transactions.
If you choose to finance your agency with debt, look for a specialty lender that understands the insurance industry and has experience working with agency acquisitions, succession planning and working capital loans. Whatever your reason for seeking capital, knowing how to weigh the options is crucial to making the best financial decision.
Alicia Chandler is president of Indianapolis-based Oak Street Funding, a First Financial Bank company.