Business owners and companies need financial resources to expand their businesses or organisations. This extra money is used to add products, open more stores, or hire more human resources. When a business has sufficient capital or money, it can grow its team, buy new machinery or equipment, or rent office space. The two major capital options for businesses or companies include equity financing and debt financing.
Keep reading to understand equity financing and debt financing and the pros and cons of equity vs. debt financing.
Debt Financing vs. Equity Financing
In finance, a business or organisation's capital structure consists of debt and equity. Both equity and debt financing have advantages and disadvantages. A company or business owner needs to decide between equity and debt capital depending on the financial situation and the company’s goals.
What is Equity Financing?
Equity financing involves selling a portion of a company’s equity in return for capital. For example, a business that creates and distributes toys needs money to buy a warehouse to store inventory and use it for packaging. To get the money for the warehouse, the business sells 5% interest in the company to an investor who is willing to provide the money needed to expand the operations. The investor now owns 5% of the toy business and can weigh in on important business decisions. The different types of equity financing include:
- Angel Investors: An investor who wants to help startups get the money they need to create and build their businesses. Angel investors receive equity in the company for their capital investment.
- Initial Public Offering (IPO): IPO is when a company goes public and investors can purchase shares in your company.
- Equity Crowdfunding: This involves soliciting money from the target audience in exchange for equity or a promise of goods or services, once the business realises its financing goals.
- Venture Capital: This involves securing venture capital from a firm made up of investors willing to combine their money to invest in either startups or small businesses.
What is Debt Financing?
Debt financing refers to a company borrowing money that they will pay back with interest. A business can obtain debt financing through a bank, financial institute, or even an investor. There are various types of debt financing options available. Some of the major ones include:
- Line of Credit: When a business has direct access to certain funds that it can use when needed. The lender sets a cap on the available capital and the business only pays interest on the money used.
- Personal Loans: These are perfect when a company is brand new and must use their assets. Securing a personal loan can help new business owners get started.
- Credit Cards: Business credit cards are also subject to some of the same terms as personal credit cards. This includes repayment schedule and interest rate.
- Conventional Loans: With these loans, a business receives the lump sump of money required. They pay back the money with interest in a predestined amount of time.
Equity Vs Debt Financing- Pros
Below is a list of equity and debt financing advantages.
| Equity Finance | Debt Finance |
| No repayment: A business is not required to repay capital it obtains through equity financing. Investors usually bet that they will make money through the sale of their stake or future cash flows. | No Profit Sharing: Debt financing allows a business to keep its profits entirely to itself. This is not the case with equity financing where investors eventually become entitled to a portion of profits. |
| Cash Preservation: Compared to other funding types, equity finance does not cost anything. This allows a business to conserve cash to grow instead of spending it on paying interest. | Independence: Investors in debt financing do not have a say in how a business is run. A start-up or business makes its own decisions on how to work completely in an independent way. |
| No Interest: As equity financing does not need debt repayment, companies do not have to worry about making interest payments. | Easy Budget Forecasting: Budget forecasting is considerably easier with debt financing as compared to other types of funding. This is because the fixed-rate loan in debt finance means the loan payments do not change and with unchanging monthly fees, predicting future expenses is easier. |
Debt Financing Vs Equity Financing- Cons
Take a look at the cons of equity vs debt capital.
| Equity Finance | Debt Finance |
| Profit Sharing: The ownership stake in equity finance entitles investors to a portion of the future profits of a business. | Interest: The monthly interest expenses can be hefty. However, any interest paid on debt financing is tax deductible. In the future, that deduction can outweigh the immediate financial burden. |
| Loss of Independence: Investors in equity financing are often more involved in a startup or a business. This means if the ownership stake is diluted because of repeated offerings, the business owners may risk losing control. | Liability: Certain debt financing providers might require a business to put assets as collateral. In case of failure to repay the loan, the lender can acquire your assets. |
| Difference of Opinion: Shareholders and business owners may not always agree on how a company should run. This could cause tremendous strife. | Repayment: Unlike equity capital, you must pay back the money you receive from debt financing. If a company is unable to generate the cash flow needed to service the debt, it may end up defaulting on the business loan. |
Why Does a Company Need Equity or Debt Financing: Strategic Applications?
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- Working Capital for Daily Operations: Every business, especially early-stage companies are consumers of cash. Equity or debt finance provides the needed working capital required to pay wages and salaries, purchase inventory, or for operating expenses.
- To Purchase Assets: A business may want to purchase assets like plant and equipment, hardware, software, intellectual property, and other long-term assets – to build the business.
- To Finance a Merger or Acquisition: Equity, debt, or a combination of both can be used to acquire another company or line of business.
- Access to Multiple Capital Sources: CFOs like access to various sources of capital as diversity in a business’s capital structure strengthens it from the point of view of lenders and investors.
Conclusion
Debt and equity financing are both avenues through which a business acquires much-needed capital or funding. Which one is required, depends on the business goals, need for control, and tolerance for risk. Before you make your decision as a finance leader or a business owner it is important that your financial and investment skills are sharp enough and you have in-depth knowledge of investment banking and financial capital.
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