Debt or equity — how to decide.
It is the first capital-structure question a growing company asks, and the one most often answered by habit rather than arithmetic. The two forms of capital are not competitors to be ranked; they solve different problems, and the right answer is whichever matches the cash flow, the purpose and the balance sheet in front of you. This guide sets out the four-part decision a finance director can run, the cost-of-capital sums you can redo on a single page, and the cases where the honest answer is not to borrow at all.
Solon advises on the debt side only. We say so at the top of this page because it shapes what follows: we have no equity product to sell you, and we will tell you when equity, or patience, is the better answer. This is general guidance for a UK lower-mid-market company, not advice on your specific facility.
Debt is a fixed claim. Equity is a permanent partner.
Debt is cheaper and it does not dilute. You pay interest, you keep every share, and once the facility is repaid the lender is gone and the upside is entirely yours. The price of that is fixed obligations: interest and amortisation fall due whatever the business is doing, and the covenants hand a lender rights over the company if performance slips. The cost is contractual and the risk sits with you.
Equity is the opposite in almost every respect. It never has to be repaid and it carries no covenant that can put you in default, so it absorbs the volatility that would trip a lender. But it is the most expensive capital you will ever raise, because you are selling a permanent share of every future pound the business earns, and it comes with a new owner at the table who has a say in how the company is run. The obligation is muted; the price is a slice of the exit, paid forever. Neither is better in the abstract. The whole of the decision is matching the instrument to the situation, and the four tests below are how you do it.
Four tests, in order.
The choice resolves along four axes. Run them in this order, because the first two settle most decisions before cost enters the room at all.
Predictability of cash flow.
The first and most decisive test. Steady, contracted, recurring revenue services debt comfortably and argues for borrowing, because the lender can see the cash that will repay it. Lumpy, seasonal, concentrated or early-stage cash flow does not: a business that looks fundable on the central case can be in breach the first time a quarter comes in light. Equity absorbs the volatility that would trip a covenant, which is precisely why volatile businesses raise it.
The purpose of the money.
Match the instrument to what the funds actually buy. Funding a known asset with a measurable return — an acquisition that adds earnings, a fit-out, a fleet — suits debt, because you can match the repayment to the cash the asset throws off. Funding something speculative with no near-term cash — a long product build, a land-grab for market share — is equity's job, because there is nothing yet for a lender to be repaid from.
The existing balance sheet.
This test sets the ceiling on how much debt is even on the table. If you are already carrying leverage, more debt compounds the fragility and the market may not offer it at any sensible price. If you are ungeared, there is real capacity to use before you reach for equity — and using it first is almost always the cheaper path. Capacity and prudence are two different numbers here: what a lender will offer is set by a good year, what you should take is set by a bad one.
Cost and control.
The tie-breaker when the first three leave a genuine choice. Debt on a lower-mid-market deal costs a single-digit margin over the reference rate, and after the tax shield the effective cost is lower still. Equity implicitly costs far more once you price the share of exit value you give away, and it dilutes both your economics and your control. The next section puts numbers on that gap — the point of this test is that it comes last, not first.
The tests are not a scorecard to be totted up. Cash-flow predictability and purpose are the load-bearing pair: a business with steady, contracted revenue funding a known asset has already answered the question in favour of debt, and one with binary, pre-revenue cash flow chasing a speculative build has answered it in favour of equity. The balance sheet sets the ceiling on how much debt is even available. Cost and control are the tie-breaker when the first three leave a genuine choice — and that is where the arithmetic in the next section earns its place.
What debt actually costs, after tax.
Start with the headline cost of debt. At the time of writing the Bank of England’s Bank Rate is 3.75%, held there since December 2025. [Bank of England, Bank Rate] A clean, secured senior facility for a lower-mid-market company might carry a margin of, say, 4.5% over the reference rate, so the headline all-in cost is about 8.25%. That is not the number that matters, because interest is deductible for corporation tax. So long as your group’s net interest is below the £2m de-minimis threshold under the Corporate Interest Restriction — which covers the whole of this market — interest is fully allowable, and no restriction arises. [HMRC, CFM95140]
At the 25% main rate of corporation tax, the after-tax cost of that facility is 8.25% × (1 − 0.25), or about 6.2%. [GOV.UK, Corporation Tax rates] A smaller company inside the 19% small-profits band would land a little higher, nearer 6.7%. Either way, the effective cost of debt for a profitable company is meaningfully below its headline coupon — a point that is easy to lose when a term sheet quotes you a margin, not an after-tax rate.
Worked example — a £5m raise
The same money, priced two ways.
Take a company that needs £5m and could raise it either way. As a facility at 8.25% headline, the after-tax cost is about 6.2%, and every share stays where it is. Now price the equity alternative. To raise £5m by selling 25% of the company implies a post-money valuation of £20m — that is simply £5m divided by 0.25. If the business is worth £40m when it sells five years later, that 25% stake is worth £10m in the buyer’s hands. You raised £5m and handed over £10m of exit value to do it.
Expressed as an annual cost, giving up £10m over five years for £5m today is an implied return to the investor well into double digits — comfortably above the ~6.2% after-tax cost of the debt. That is the shape of the trade-off, and it is why taking equity you did not need is an expensive mistake you cannot undo. The figures here are illustrative, not a valuation: change the exit value or the hold period and the gap moves. But the direction does not. Where a business generates cash and the use of funds has a return, debt is usually the cheaper tool by a wide margin.
The sum flips in exactly the situations the framework predicts. If the company is loss-making, there is no taxable profit for the interest to shelter, so the tax shield is worth nothing and the full 8.25% bites. If the cash flow cannot reliably cover the interest, the “cost” of debt is no longer a rate at all — it is the risk of a covenant breach, which is a cost no spreadsheet captures. And at the top of the price range, a private-credit facility at the institutional end runs far dearer than a bank term loan, so the arithmetic that favours borrowing over equity narrows sharply when the only debt on offer is the most expensive kind.
For how the cost of a facility builds up across the market — and why the cheapest coupon is rarely the best deal once you count covenant headroom — see the covenant that bites first and the pricing answers in the guides.
A lender underwrites the downside. An investor buys the upside.
The two forms of capital are sold to different audiences, and the case that wins one can actively lose the other. A lender is repaid a fixed amount and no more, so it underwrites the downside: it wants to believe the business will still service the debt in a bad year. It reads contracted revenue, cash conversion, asset cover and the margin of safety in the forecast. An ambitious growth story is, to a lender, mostly additional risk it is not paid to take. This is why the UK lower-mid-market is well served on the debt side: gross SME bank lending reached £68bn in 2025, and challenger and specialist banks now provide 60% of it, so a fundable credit has real competition to run. [British Business Bank, Small Business Finance Markets 2026]
An equity investor is the mirror image. It shares fully in the upside and can lose its whole stake, so it underwrites the upside: it wants to believe the business can be worth a multiple of today’s value, and it will accept years of reinvestment and no distributions to get there. The steady, cash-generative profile a lender loves is, to an equity investor, often the sign of a business that will not deliver the return the fund needs. The practical consequence is that if you find yourself straining to make a debt case — discounting the risks, leaning on the best year — you may be trying to sell a lender an equity story, and the market is telling you which instrument the situation calls for.
It is rarely one or the other.
Debt and equity are not mutually exclusive, and the best answer is usually a blend: a sensible layer of debt topped by only the equity needed to fund the part debt cannot reach, which holds dilution to the minimum the plan requires. Sequencing that blend well is a real source of value, and it follows a few rules.
Debt is usually cheapest, so use its capacity first.
For a profitable, cash-generative business, the after-tax cost of senior debt sits well below the implied cost of equity. The discipline is to size the debt layer against a downside forecast — revenue down, a customer lost — so an ordinary bad quarter is an inconvenience, not a covenant breach, and only then bring in equity to fund what remains. That order minimises dilution without over-gearing.
Debt commonly comes after an equity round, not before.
Lenders price off the balance sheet in front of them. A fresh equity injection thickens the equity cushion beneath the debt and improves the leverage ratio, so the same business can often borrow more, and more cheaply, straight after a round than before it. Where both are planned, sequencing the equity first and the debt against the strengthened balance sheet is frequently the lower all-in cost of capital.
Junior debt is the layer between — priced accordingly.
When senior debt reaches its ceiling and you would rather add debt than dilute, mezzanine or other junior debt sits behind the senior lender and is priced for that risk: typically low-to-mid-teens all-in, often part cash-pay and part PIK, where the rolled-up interest compounds. PIK at 12% grows a balance by roughly 57% over four years, so a slow exit can consume real equity value before the shareholders notice. It earns its place for a sponsor optimising returns or a shareholder buying out a partner — for an ordinary trading business it is usually a sign of borrowing too much.
The priciest capital goes last, and only when nothing cheaper fits.
Cost rises across the lender spectrum, and private-credit funds sit at the dearest end — you pay that premium for cashflow underwriting, higher leverage and certainty of execution, not because it is a better product. It is the right answer only when cheaper sources decline or cannot do the structure. Reaching for it first, when a bank or specialist lender would have done the deal, is one of the more expensive errors in the sequence.
On sizing the debt layer against a downside case rather than the central plan, see refinancing from strength, not necessity. On why the priciest capital belongs last, and only when nothing cheaper fits, see what a trillion of private credit means for a UK borrower.
Where borrowing is the wrong tool.
The cases where borrowing is the wrong answer are worth naming plainly, because a lender never will, and because the tell in almost all of them is the same: the debt makes the central case look fine and the downside case look frightening.
When the cash flow cannot safely service it.
Debt is a fixed claim: interest and amortisation fall due whatever the trading is doing. A business with lumpy, seasonal or concentrated revenue can look fundable on the central case and be in breach the first time a quarter comes in light. If the plan only works when nothing goes wrong, the leverage is too high, and the honest answer is less debt, equity to absorb the volatility, or none.
When the money funds a loss, not an asset.
Debt bought against a real return — an acquisition that adds earnings, plant that lifts capacity — works because the asset repays the loan. Debt drawn to cover a structural cash shortfall, to prop up a business that is not yet profitable, or to plug a hole that will simply reopen, converts an operating problem into a solvency one and shortens the runway. That is equity's risk to take, or no one's.
When the price of the deal is a structure that owns you.
A covenant package with no headroom, a personal guarantee over the family home on a business that cannot really support the borrowing, an aggressive cash sweep that starves the company of reinvestment — these can cost far more than the interest, and a borrower under time pressure signs them too readily. Terms, not just price, decide whether debt is the right tool.
When you are borrowing to time the market or avoid a decision.
Gearing up to take cash off the table in a business already stretched, or refinancing early purely on a rate view you cannot win, is borrowing for the wrong reason. So is reaching for debt because raising equity means a harder conversation about ownership. The instrument should follow the need, not the path of least resistance.
The discipline is to size every facility against the bad year, not the good one, and to walk away when the numbers only work in the good one. This is where an adviser paid by the borrower, not the lender, earns its keep, because the incentive to complete a transaction runs the other way for almost everyone else in the room. On a meaningful share of the situations that reach us, the right recommendation is to borrow less than the business could raise, to wait, or not to borrow at all. If you are better served by equity, by patience, or by staying with your existing bank on its current terms, that is what we will tell you. The fuller treatment of the wrong-answer cases lives in the guides.