Equity Financing vs. Debt Financing: An Overview
To raise capital for business needs, companies mainly have two types of financing options: equity financing and debt financing. Most businesses use a combination of debt and equity financing, but both have distinct advantages. Chief among them is that equity financing has no repayment obligations and provides additional working capital that can be used to expand a business. Debt financing, on the other hand, does not require giving up part of the property.
Businesses generally have the choice of seeking debt or equity financing. The choice often depends on the most easily accessible source of financing for the business, its cash flow and the importance of maintaining control of the business for its principal owners. The debt-to-equity ratio indicates the share of a company’s financing that is proportionally provided by debt and equity.
Key points to remember
- Two types of financing are available to a business when it needs to raise capital: equity financing and debt financing.
- Debt financing involves borrowing money, while equity financing involves selling a portion of the company’s shares.
- The main advantage of equity financing is that there is no obligation to repay the money acquired through it.
- Equity financing does not impose any additional financial burden on the company, but the disadvantages can be quite significant.
- The main advantage of debt financing is that a business owner does not give up any control of the business as they do with equity financing.
Equity financing involves selling a portion of a company’s equity in exchange for capital. For example, the owner of Company ABC might need to raise capital to fund the expansion of his business. The owner decides to give up 10% ownership of the business and sell it to an investor in exchange for capital. This investor now owns 10% of the company and has a voice in all future business decisions.
The main advantage of equity financing is that there is no obligation to repay the money acquired through it. Of course, the owners of a business want it to succeed and provide investors with a good return on investment, but without payments or interest charges, as is the case with debt financing.
Equity financing does not impose any additional financial burden on the company. Since there are no required monthly payments associated with equity financing, the business has more capital available to invest in business growth. But that doesn’t mean there isn’t a downside to equity financing.
In fact, the downside is quite significant. In order to get financing, you will need to give the investor a percentage of your business. You will need to share your profits and consult with your new partners whenever you make decisions affecting the business. The only way to weed out investors is to buy them out, but that will likely cost more than the money they originally gave you.
Debt financing involves borrowing money and paying it back with interest. The most common form of debt financing is a loan. Debt financing sometimes comes with restrictions on a company’s activities that can prevent it from taking advantage of opportunities outside of its core business. Creditors look favorably on a relatively low debt ratio, which benefits the company if it needs to access additional debt financing in the future.
The advantages of debt financing are numerous. First, the lender has no control over your business. Once you have repaid the loan, your relationship with the financier ends. Then the interest you pay is tax deductible. Finally, it is easy to predict expenses because loan repayments do not fluctuate.
The downside of debt financing is very real for anyone in debt. Debt is a bet on your future ability to repay the loan.
What if your business goes through a tough time or the economy once again experiences a meltdown? What if your business is not growing as fast or as well as expected? Debt is an expense and you have to pay expenses on a regular schedule. This could put a damper on your business’ ability to grow.
Finally, although you may be a Limited Liability Company (LLC) or other business entity that offers some separation between business funds and personal funds, the lender may still require you to secure the loan with the assets. your family’s finances. If you think debt financing is right for you, the US Small Business Administration (SBA) works with select banks to offer a secured loan program that makes it easier for small businesses to get financing.
Example of equity financing and debt financing
ABC Company seeks to expand its business by building new factories and purchasing new equipment. She determines that she needs to raise $50 million in capital to fund her growth.
To obtain this capital, ABC Company decides to do so through a combination of equity financing and debt financing. For the equity financing component, she sells a 15% stake in her company to a private investor in exchange for $20 million in capital. For the debt financing component, it obtains a commercial loan from a bank in the amount of $30 million, at an interest rate of 3%. The loan must be repaid in three years.
There could be many different combinations with the example above that would result in different results. For example, if Company ABC decided to raise capital solely with equity financing, the owners would have to cede more ownership, which would reduce their share of future profits and their decision-making power.
Conversely, if they decided to use only debt financing, their monthly expenses would be higher, leaving less money available to use for other purposes, as well as more debt than they should repay with interest. Businesses need to determine which option or combination works best for them.
Which one is right for you depends on several factors such as your current profitability, your future profitability, your dependence on ownership and control, and whether you can qualify for one or the other. The different types and sources for each type of funding are described in more detail below.
Some sources of debt financing are:
- Term loans
- Lines of business credit
- Factoring invoice
- Business credit cards
- Personal loans, usually from a family or friend
- Loan services between individuals
- SBA Loans
The ability to obtain debt financing largely depends on your existing finances and creditworthiness.
Some sources of equity financing are:
- angel investors
- venture capital business
- Corporate investors
- Stock exchange listing with initial public offering (IPO)
Obtaining equity financing can be a simpler process than debt financing, but you must have an extremely attractive product or financial projections, as well as being able to hand over part of your business and often good control .
Why would a company choose debt financing over equity?
A company would choose debt financing over equity financing if they do not wish to divest part of their business. A company that believes in its finances would not want to miss out on the profits it would have to pass on to shareholders if it allocated equity to someone else.
Is debt cheaper than equity?
Depending on your business and its performance, debt may be cheaper than equity, but the reverse is also true. If your business is not making a profit and you close, your equity financing will essentially cost you nothing. If you take out a small business loan through debt financing and you don’t make a profit, you still have to repay the loan plus interest. In this scenario, debt financing is more expensive. However, if your business sells for millions of dollars, the amount you pay out to shareholders could be much higher than if you had retained that ownership and simply paid off a loan. Every circumstance is different.
Is debt or equity financing riskier?
It depends. Debt financing can be riskier if you are not profitable, as your lenders will put pressure on loans. However, equity financing can be risky if your investors expect you to make a substantial profit, which they often do. If they are not satisfied, they could try to trade cheaper stocks or divest completely.
Debt and equity financing is a way for companies to acquire the necessary financing. Which one you need depends on your business goals, risk tolerance, and need for control. Many early-stage businesses will seek equity financing, while those already established and those with no debt issues and strong credit ratings might seek traditional types of debt financing such as loans to small enterprises.