Overview Equity Financing VS Debt Financing

Overview Equity Financing VS Debt Financing

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To raise capital for business needs, companies primarily have two types of financing as an option: equity financing and debt financing. The majority of companies apply the debt and equity financing, however, there is a huge difference between these two types of financing. The main reason is that equity financing involves no repayment obligation and, in addition, it provides extra working capital that can be used for business expansion. Debt financing, apart from others, does not require giving up a share of ownership. 

Companies typically are given a choice either to pursue debt or equity financing. The choice always depends on which one of the funding sources are most easily accessible for the company, its cash flow, and whether or not maintaining control or ownership of the company is important to the principal owners. The debt-to-equity ratio demonstrates the proportion of company funding that is secured by debts and equity.

Debt Financing

Debt finance is a loan type that requires repayment of the borrowed money with an additional interest. The most standard debt tool is the loan. Debt financing, sometimes, includes restrictions on the company’s activities. This, many times, prevents the company from taking chances outside the realm of its core business. The creditors will likely be in favor of the low debt/equity ratio given the situation, which will be a good sign for the company if in the future it has to finance new debt.

What if your organization encounters a tough period or the economy enters into a recession crisis again? And what if your business does not grow as fast and as well as you had anticipated? The debt is your expense, and you pay for it on the schedule. It would slow down your company’s growth.

Additionally, you might be an LLC or other type of company that provides some separation between the company and your personal funds but the lender may still need you to guarantee the loan with your family’s financial assets. If you look at debt financing as the best option for your small business, the U.S. Small Business Administration (SBA) operates a guaranteed loan program that is partnered with select banks to make the process for small businesses to secure funding smoother.

Equity Financing

Equity financing entails selling a part of the business ownership in exchange for capital. For example, the owner of Company ABC may want to raise money to finance the business growth. The owner chooses to give up the 10 % of the ownership of the company and sell it to an investor who will contribute to the funds in exchange. The investor now owns 10% of the company and is given a voice in all business decisions to come.

The principal benefit of equity investment is that we are under no obligation to pay back the money taken from it. In addition, it is obvious that company’s owners would desire the business to thrive and grant the equity investors a good return on their investment. However, unlike debt financing, where payments of interest on principal are required, equity financing does not require such a payment.

Equity financing has no financial pressure on the company, as it does not require repayment. Since equity financing is not based on monthly repayment slots, the business itself can use the extra capital for its development. However, the fact that there’s no disadvantage linked to equity financing isn’t entirely true.

The downside is equivalently huge. Investors are willing to invest but be ready to exchange the part of the company ownership for it. After your startup becomes more successful, you will have to share your profit and discuss all decisions concerning the company with your new partners. The only way to remove your investors is to buy back the equiry which will be probably higher than the money you got from investors initially.

Debt Financing VS Equity Financing

Company ABC is planning to broaden its operations through infrastructure development and acquisition of new production machinery. The round size will be set at $50 million for the fundraising purpose as it expands.

To achieve the company’s aims in this capital, the firm will choose to use a mix of equity and debt financing. On the equity side, it would provide 15% interest in its business to a private investor in exchange for $20m in capital. For debt financing, it borrows $30 million from a bank with an interest rate of 3%. The term of the loan is fixed for 3 years.

In the above example, there can be numerous variations from the combination of the circumstances that would end up with different results. For instance, if Company ABC conducts equity financing exclusively then the owners have to give up their larger part of future profits and cede their decision-making power too.

They could have gone for the opposite policy as well instead of just using debt financing, the costs would be higher with only less funds that can be used for other reasons, and it would have a lot of debt that would have to be paid back monthly with an accrued interest rate. Businesses have to get themselves involved in this particular decision process, which option is the one for them or which combination should be considered.

Additional Factors

Deciding which one works the best for you is determined by some variables which involve the status of profitability, future profitability, dependency on ownership, and ability to apply for one or the other. The various options, including types, and origin for each finance type, are explained in the next section.

Debt Financing

Some forms of debt funding include:

  • Term loans are a form of financing where a lump sum is borrowed and repaid over a specified period with interest.
  • Business lines of credit provide companies with access to a predetermined amount of funds that can be drawn upon as needed, with interest paid only on the amount utilized.
  • Invoice factoring involves a company selling its accounts receivable to a third party at a discount to obtain immediate cash flow.
  • Business credit cards are credit cards issued specifically for business expenses, offering various benefits and rewards tailored to business needs.
  • Personal loans, typically obtained from acquaintances or family members, are funds borrowed for personal use.
  • Peer-to-peer lending services connect individuals or businesses in need of funds with investors willing to lend, bypassing traditional financial institutions.

The option of receiving debt financing is mainly dependent on your financial records and your creditworthiness rather than your business plan and credit rating.

Equity Financing

Some forms of debt funding include:

  • Angel investors are individuals who provide capital to startups or small businesses in exchange for ownership equity or convertible debt.
  • Crowdfunding involves raising small amounts of money from a large number of people, typically via online platforms, to fund a project or venture.
  • Venture capital firms are investment firms that provide capital to startups and small businesses in exchange for equity ownership, with the aim of generating a high return on investment.
  • Corporate investors are companies or corporations that invest in startups or other businesses either directly or through venture capital funds, often seeking strategic partnerships or opportunities for growth.
  • IPO (Initial Public Offering) refers to a company’s shares becoming publicly traded on a stock exchange, allowing investors to buy and sell them freely.

Conclusively, it should be admitted that equity financing is the easier one though you need a very convincing proposition or convenient financial plan for giving away part of the company and once being in control.

Why Might A Company Prefer Debt VS Equity Financing?

A business would often go for debt financing as compared to equity financing if it aspires to maintain the full ownership and control of the business. Through borrowing, the company doesn’t need to do dilutions and is not obliged to distribute profits with their shareholders. Furthermore, if the company is optimistic about its finance and it could pay its debts, it may tend to use the assets or the future cash flows to get credit rather than to sell the ownership which is equity financing.

Is Debt Cheaper Than Equity?

Your business debt, as a rule, is cheaper than equity, however, here equity is also involved. The most persuasive point about equity financing is that in the case of your business forecasting to make a loss and shut down, the equity investors would lose nothing. Even worse, the debt financing will make you repay whatever you have borrowed plus the interest, even if your small business is going down and you cannot spend money. Then it can be said that in this case, debt financing is more expensive. However, if the company is sold for millions of dollars, the payment you owe the shareholders is more than this figure, which is a loan that you would be paying without having sold your shares. Every situation is different.

Which Form Of Financing Do You Consider Riskier: Debt Or Equity?

It depends. In this scenario, after using debt financing, you may be exposed to a riskier position than before because of pressure from a loan if you are not profitable enough to pay it off. The contrary of this is the risky nature of debt financing when you have investors who expect returns even in cases where they don’t get any. If they are not agree with the valuation, they might request another one to be less or they can just call it quit.

Debt and equity financing are two types of capital businesses are supplied with. The choice depends on whether your goals for the business are risk-averse, risk-tolerant, or somewhere in between as well as how much control you want to have. A large number of new ventures will prefer the equity investment option rather than the debt financing which will mostly attract established businesses and businesses which do not have any problems in obtaining loans and whose credit records are known by the creditors.

How Can Fastlane Help You?

If you are starting a business and need help with choosing which financing method to use to grow your capital, our team of experts from Fastlane can consult you. Fastlane offers financial services like accounting and bookkeeping, audit, tax compliance, and advisory services. FastLane’s professional bookkeeping services enable account maintenance and preparation of audited financial statements.

Contact us to find out more about how we can support your success!

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