Debt and Equity Financing
Debt financing is the process of raising capital through the sale of fixed-income products such as bonds, bills, or notes to investors (1). It is money borrowed that you pay back with interest within an agreed-upon period.
The most common examples of debt financing include bank loans, overdrafts, mortgages.
Advantages of Debt Financing
- Maintaining ownership:
The institution or individual lending you the money has no say in how you run the business. The business relationship ends once the loan is repaid.
- Tax deductions:
The loan interest expense is tax-deductible, effectively reducing your net obligation
- Retaining profits:
There is no sharing with the lending party.
Disadvantages of Debt Financing
Debt financing is only available for businesses that meet the qualification requirements, such as a good enough credit rating.
By providing collateral, you put some of the business assets at potential risk.
The agreed-upon installments have to be repaid on specific dates without fail. Businesses with unpredictable cash flows might have difficulties making repayments. Repayments can also adversely affect the company’s cash flow.
- Credit rating:
Failure to make the repayments required can affect the company’s credit rating, which will affect future credit applications.
Equity financing is the process of raising capital through the sale of shares (2). It involves selling a portion of the company to investors, who purchase ownership rights to the company.
A private company raises equity financing from angel investors, crowdfunding platforms, corporate investors, or venture capital firms. For example, an angel investor can provide the needed capital to finance growth for a 30 – 50% stake in the company. When a company eventually goes public, funds are raised through the sale of shares in an IPO.
Advantages of Equity Financing
- No repayment obligation:
The business doesn’t have to make monthly loan repayments, which is particularly crucial if the company doesn’t initially generate profits.
- Access to extra business resources and expertise:
Some investors provide invaluable contributions such as access to wider networks, expertise, and other sources of capital.
- An alternative source of funding that is collateral-free:
Equity financing provides an alternative financing source for businesses that don’t qualify for large bank loans. It also does not require a pledge of collateral. Assets purchased with equity financing can be used to secure future long-term debt.
Disadvantages of Equity Financing
- Dilution of ownership and operational control:
Investors have financial and governance rights that dilute ownership and control of a company and increase management oversight (3).
- Share profits:
Profits are shared amongst the shareholders. The legal restrictions that govern the use of equity financing determine the dividend returns received by each investor.
- Lack of tax shields:
Distributed dividends are not tax-deductible, as is the case with the interest expense for debt financing.
What is the best long-term liability financing for your business?
Almost all businesses, including start-ups, need to bring in outside funds at some point to fuel growth.
Equity financing is vital during a company’s startup stage when finances are necessary to acquire assets and cover the initial operating expenses. It is ideal when:
- Business creditworthiness is an issue.
- You don’t mind sharing your decision-making and control rights.
- You would rather share ownership/equity than repay a bank loan.
- You don’t mind sharing profits.
Debt financing is best if you:
- Need to retain full ownership and control.
- Are comfortable making monthly repayments
- Qualify for debt financing.
- Have collateral to use, and you are comfortable using it.
In the long run, equity financing is considered more costly because investors incur a high risk when funding a company and expect a higher return to counter the risk.
References used to write this article – Debt and Equity Financing
- Chen, J. (n.d.). Debt Financing. Investopedia. (URL)
- Corporate Finance Institute. (2020, August 13). Equity Financing. (URL)
- Nordmeyer, B. (2019, August 8). Advantages & Disadvantages of Equity Capital. Finance – Zacks. (URL)
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