Aim of the Chapter
Key concepts introduced in the chapter
What is Development Capital?
Development capital is capital raised to grow a business, normally by investing in additional productive assets but it can include funding growth by acquisition or the provision of additional working capital in businesses in which there has to be considerable and continuing investment in stock or work in progress. Development capital can be provided by both loan finance and equity finance.
Loan or equity finance?
This is not as straightforward a question as it might at first seem. To many managers the overwhelming priority is not to give away equity unnecessarily and therefore borrowing is the first route they examine when considering raising development capital. This is sensible not only because it does not involve the surrender of rightly precious equity, but also because the appraisal and approval process which the lender will follow is much simpler, and above all quicker, than that which the potential equity investor would undertake.
In the middle 1980s, moreover, the banks were very keen to write new lending business. It was easy to raise both term loans and overdraft against property in an environment where the security value of property seemed to just grow and grow. However, in the early 1990s the situation has radically altered; LDC debt, the poor performance of UK commercial borrowers in the recession and the effects of the Basle Accord on capital adequacy have all combined to alter the bank's attitude to lending. Not only are they extremely cautious about offering new facilities but they are trying to reduce their exposure to existing borrowers.
Therefore it is sensible to consider funding growth by raising equity finance even for companies who may have the ability to borrow the money they need. If there is any doubt about the adequacy of the security cover which a management team is considering offering a lender, or any doubt about the business' ability to service the interest, then raising equity may be a better alternative. There is nothing more damaging than to have negotiated a facility which is adequate to its purpose and then have it reduced because of some unforeseen change in the value of the underlying security, something which is very common now but which also happened in the early 1980s in areas of extensive industrial closures.
Finally, it is worth mentioning interest rates. A banker who worked for one of the lenders involved in the 1988 buy out of MFI from Asda recalled that they had modelled a worse case interest rate of 12% at a time when prevailing rates were 8 or 9%; within eighteen months base rates were 15% and commercial borrowing rates 16% and over.
Investors' and lenders' expectations
Forecasting lies at the heart of persuading both investors and lenders to finance company development. They will want to see a clearly worked forecast which shows the reasonable future performance of the business based on sensible assumptions.
The investor will be looking to see the market potential in the company's products or services, current and future, which justifies the proposed investment in new productive or operational capacity, or the acquisition of a subsidiary. The equity investor
