When a business seeks funds through investors, it considers two options: debt vs equity. Debt financing involves borrowing funds from investors by issuing corporate bonds. Equity financing involves selling the part of ownership rights in the company to investors by issuing stocks. The reward the investors receive for financing companies is through interest and dividends.
When a business borrows money to finance its operations in the form of loans, it agrees to repay them within a time frame and with interest to an investor.
- Debt Financing
- Equity Financing
- Debt vs Equity: Key Factors to Note
- How to decide to debt vs equity
The loan might be from banks as a commercial loan or from friends and family. A credit card and a secured business line of credit are the other forms of debt financing.
All forms of debt financing have one thing in common: the company has to return the principal amount along with interest.
Companies favor debt financing as the loan interest payments are tax-deductible, and the company does not part with the ownership rights. Investors favor the investment in debt because it ensures that they will receive a fixed amount of income for a specific time period.
Equity financing involves the issue of shares of stock of the company to investors to raise funds. The shares symbolize the unit of ownership of the company. The investors do not receive a fixed income like in the case of debt financing. The company issuing the shares pays a dividend at their discretion only.
Equity financing always involves investors giving capital to promising business startups/companies in exchange for ownership of the company. The investors want the return if the company goes public.
The businesses favor equity financing because they are not lawfully accountable for repaying the money. Investors prefer equity because the stock price can rise considerably, giving a good return on their investments.
Debt vs Equity: Key Factors to Note
The business has to decide how to raise money through debt or equity. But before choosing, they should understand the nuances of both.
Equity Financing is Best for Startups with High Business Potential
Equity financing is favorable for innovation and high-risk technologies startups. These startups have the potential to generate a good return on investment. Equity financing is also beneficial for businesses in industries that do not have a stable cash flow.
The investors invest in these startups because they want to make high gains on their investments. Some investors have industry preferences. However, business owners need to consider the current business and future goals when considering debt and equity.
Equity Financing Separates Ownership Control
Equity financing needs the business owners to part with their ownership and some control.
There are two types of investors that will invest in the company. One, those who invest in the company become part owners but do not involve themselves in any decision.
Others are those who want control over the future of business. They own the part of the business and want to make money from it.
This can be both good and bad. Investors who have knowledge about the business and successful businessmen themselves can be a great asset for the business. They can help in making sound business decisions.
Whereas the investor with little knowledge or the investor whose business ideology does not meet with the business owner can be very stressful. The business owner will always face challenges operationally and strategically. These investors may persuade the owners to take a step forward that they might not be ready to take.
Now, if we consider debt vs equity, debt seems to be a safer option. In debt financing, the investor does not take ownership, therefore, does not interfere in the decision-making. Once the business pays off the debt, there is no further relation with the investor.
How to decide to debt vs equity
Taking debt financing is always considered to be a better option than giving equity of the business. By giving equity, the owners give part of the control of the business to investors. Thus, not only affecting today’s business decisions but also complicating future ones by involving the investors.
For short terms needs for money, debt financing is better as that leaves the owners with full control over the business (as long as they repay the debt on time).
However, to decide between debt vs equity financing for the business, owners need to consider the current needs and plans of the business. Some common situations are listed below where the owner has to consider between debt vs equity.
Small Amount of Capital is Required
Debt financing is always beneficial when a small amount of capital is needed. Venture capitalists and big investors rarely make small investments, so if a business needs capital of small amounts, they need to look into debt financing.
Giving up a part of equity is a big business decision that should not be taken lightly. Giving away equity for solving short-term needs is not a good decision. If the business faces a short-term or temporary money shortage or requires funds for growth plans, it should look for short-term financing solutions. They can repay the debts once the situation is over.
Big Growth Plans
Suppose the business owner expects their business to have high growth potential and they have a sound business plan, financial projections, and relevant data to convince the investors. In that case, they can consider venture capital financing. They need a strong management team, a business plan that is likely to generate a good return, and the ability to sell the concept. They should be able to generate the return in a short time frame- say two to five years.
Expert Guidance than Money
Sometimes, a business needs mid-range capital, but they need expert guidance along with capital. Equity investment is a perfect solution for them. Having an investor with prior knowledge of the industry can be a blessing, as they can use their expertise in the business. Many of these investors are willing to involve themselves in monitoring and guiding the business owners.
Urgent Need of Money
When the business requires funds immediately, or in a short time, debt financing is a solution. The process of getting debt financing is much faster than equity financing. The process of equity financing is long. First, find and pitch to an investor, then all the documentation and paperwork. It takes a long time to receive money. In contrast, an online debt financing solution can get you the money within a few days of applying.
Cost of Raising Funds
In terms of cost, equity is a comparatively more expensive source of capital, but it offers more financial flexibility. In contrast, debt is comparatively cheaper but comes with a lot of obligations. Debt is a fixed obligation for a company, but there is no such obligation with equity.
Whether a business takes debt or equity financing depends upon the need and requirements of the business. Debt and equity both are solutions that can solve the fund-related problems of the business. Both debt and equity have their advantages and disadvantages. It is up to the owner to select which suits the business needs.