Equity vs Debt Financing – We Explain the Differences & Compare the two
Financing your business is one of the biggest decisions you and your company will have to make.
It is already a well-known fact that cash is needed to keep a business afloat.
Now while it’s ideal if you can finance your business from cash inflows from business operations alone, if you want your business to expand, you will likely have to look for external sources of funding.
There are primarily two types of financing: Equity Financing and Debt Financing.
Most companies would have a mix of debt and equity financing.
Both have their advantages and disadvantages, and in this article, we will be learning about these two types of financing.
Equity financing seeks funding from investors in exchange for a share of ownership of the company.
For corporations, it would be akin to issuing and selling new stocks (or treasury stocks).
For partnerships, it may be an additional investment of an existing partner, or maybe even the welcoming of another partner.
For a sole proprietorship, it may be the owner adding more capital to the business, or maybe changing the business structure into a partnership.
The gist is, equity financing is additional funding for a company in exchange for a share of ownership.
It is a form of investment from the point of view of the financer.
For example, a wealthy investor purchased the equivalent of 20% shares of GT company (who is seeking to expand its business).
This wealthy investor then gains 20% ownership of GT company as a result of this transaction.
There are several sources of equity financing which could include the following:
- Angel Investors – these are wealthy individuals who seek to claim ownership (or a part of it) of a business that they think has the potential to bring in great profits; aside from funding, angel investors can also offer their experience, knowledge, expertise, and connections which can help in the growth of the business
- Crowdfunding platforms – these are avenues where many people can invest in a company, even in small amounts; crowdfunding usually has a set goal of amount to collect, and the members of the public contribute so that they can reach the said goal
- Venture Capital Firms – also referred to as private equity financing, venture capital firms refer to groups of investors who invest in businesses that are promising and have high chances of appearing in the stock market; since they are a group of investors, they have the power to invest in a larger share of the company compared to individual angel investors
- Corporate Investors – these are large companies that seek to finance private companies, usually to create a strategic relationship between the two businesses
- Initial Public Offerings (IPOs) – usually done by private corporations that decided to go public, Initial Public Offerings (IPOs) allows a company to raise fund by offering its shares/stocks to the public
The main advantage of equity financing is that it offers businesses another way of securing funds other than through debt.
This is especially useful for new and upstart companies that don’t have an established credit history yet and cannot rely on loans as a source of funding.
Equity financing does not increase a company’s financial obligations. Unlike loans, you don’t have to worry about annual payments and interests.
Equity financing instead increases a company’s capital, which it can then use for expansion or other investments.
On the part of the investors, they would want the company that they invested in to be successful so that they can reap the benefits of their investment, and as such would be more willing to contribute and share knowledge for the success of the business.
But of course, the downside of equity financing is that you’ll be giving up a share of ownership.
This isn’t an issue for already established companies, but for new ones, the loss of total control and autonomy might be a big turn-off.
Aside from ownership, you’d have to share the profits with the investors.
Debt financing seeks funding from lenders. It involves the company borrowing money from creditors to finance its operations and investments.
A loan is an example of debt financing, as it involves borrowing upfront cash from a bank or any other financial institution in exchange for scheduled repayments and interest.
Some debt financing agreements may be stricter than others such as requiring collateral or restricting the use of cash to business operations.
The point is, debt financing is an injection of cash in exchange for the obligation to repay along with payment of interests.
The common types of debt financing are bank loans and the issuance of bonds.
The main draw of debt financing is that while it increases the company’s financial obligations, it does not give up any share of the ownership of the business.
The lender does not become an owner (or part-owner) of the company, and when the obligation is fully paid for, the relationship between the company and the lender ceases to exist.
The lender cannot involve themselves in the decision-making of the business.
Another advantage of debt financing is that the payments made for interests are tax-deductible.
This reduces the company’s tax obligations.
This is an advantage of debt financing which equity financing does not have.
Dividends are not deductible and are even taxed on the part of the shareholder.
Furthermore, since principal and interest payments are scheduled and are fixed, it’s easier to account and budget for.
However, the fixed schedule of payments can also be a disadvantage. Whether the company is earning or not, the obligation to pay does not change.
You would have to pay according to schedule or your credit score will suffer.
This is more emphasized when collateral is involved.
Should the borrower be unable to pay, the creditor may claim the collateral to satisfy the obligation.
Equity Financing or Debt Financing, which one should I choose?
Let’s say you are a sole proprietor and you’re looking to expand your business.
However, you cannot do so with your current cash and capital.
Therefore, you seek out other sources of funds.
You then stumbled upon equity financing and debt financing.
You find out that you’re eligible for both! But you can’t decide which type of funding to go for.
Should you go for equity financing?
Or should you go for debt financing?
Both have their advantages and disadvantages.
Here’s a quick view of them:
So whether to go equity or debt financing would depend on what you’re willing to let go of in exchange for additional funding.
Are you willing to let go of a part of the ownership of your business?
Then equity financing might be the right one for you.
And aside from receiving funding, your investor might be able to share his/her knowledge and expertise which you can then use for the growth of your business.
Are you okay with incurring future expenses in exchange for immediate cash?
Then debt financing might be suitable for you.
You won’t have to give up full ownership of your business this way.
Just make sure that you’re able to meet the scheduled payments.
Or you can go for both. Most companies, especially the larger ones, have a mix of debt and equity financing.
In some cases though, debt financing might not even be an option.
Whatever the case may be, whether to go debt or equity financing is a choice that is to be made by the company based on needs and circumstances.