Debts and Equity Financing
Companies mainly have two forms of funding options for raising capital for business needs: equity financing and debt financing. Most businesses use a mix of debts and equity financing, but each has its own set of benefits. Companies usually have the option of seeking debt or equity funding. The decision is also based on which source of financing is the most convenient for the company, its cash flow, and how important it is to the company’s principal owners to retain control.
Debts Financing in Business
Debt financing entails taking out a loan and repaying it with interest. A loan is the most common form of debt financing. Debt funding may also come with limitations on a company’s operations, preventing it from pursuing opportunities outside of its core market. What if your business runs into trouble or the economy collapses once more? What if your company doesn’t develop as quickly or as well as you anticipated? Debt is an expense, and costs must be paid on a regular basis. This might stifle the company’s ability to expand.
How it Works?
When a business needs capital, it has three options: sell equity, take on debt, or use a combination of the two. The term “equity” refers to a company’s ownership interest. It gives the shareholder a claim on future earnings without requiring repayment. Equity investors are the last to earn capital if the corporation goes bankrupt. Debt funding is when a company sells fixed income securities to investors, such as bonds, bills, or notes, to raise the funds it needs to develop and expand its operations. When a company issues a bond, the bond is purchased by lenders, who are either retail or institutional investors who offer debt funding to the company.
Advantages of Debts Financing
There are several benefits of debt financing. Debt funding has the benefit of allowing a company to turn a small sum of money into a much larger sum, allowing for faster growth than would otherwise be feasible. Another benefit is that debt repayments are normally tax free. To begin with:
- The lender has no influence over your business.
- When you repay the loan, the friendship with the lender is over.
- And there’s the fact that the interest you pay is tax deductible.
- Finally, since loan payments do not fluctuate, it is simple to estimate expenses.
Disadvantages of Debts Financing
The key drawback in debt financing is that:
- Interest must be charged to lenders, resulting in a payment that is greater than the amount lent.
- Debt payments must be made regardless of sales, which can be especially dangerous for smaller or younger companies
- Smaller companies have yet to develop a reliable cash flow
- For companies with volatile cash flow, debt funding may be dangerous.
Equity Financing in Business
The process of raising capital through the selling of shares is known as equity financing. Companies collect money for a variety of reasons, including a pressing need to pay bills or a long-term target that necessitates funds to invest in their expansion. A corporation essentially sells ownership of their company in exchange for cash as it sells shares. Equity funding can come from a variety of places, including an entrepreneur’s friends and family, as well as investors. While the term “equity financing” usually refers to the financing of publicly traded firms, it may also apply to private sector financing.
How it Works?
The sale of common equity, as well as other equity or quasi-equity securities such as preferred stock, convertible preferred stock, and equity units that contain common shares and warrants, is part of equity financing. As a startup develops into a profitable business, it will go through multiple rounds of equity funding. Since a startup usually attracts a variety of investors at different stages of its growth, it may use a variety of equity instruments to meet its funding needs.
The corporation bears no undue financial pressure as a result of equity funding. Since there are no required monthly payments with equity funding, the company has more money to invest in the business’s development. However, this does not negate the fact that equity financing has drawbacks.
Advantages of Equity Financing
The key benefit of equity funding is that:
- The capital obtained from it is not subject to repayment.
- A company’s shareholders want it to succeed and give equity holders a good return on their investment
- Debt funding, there are no mandatory payments or interest costs.
- The corporation bears no undue financial pressure as a result of equity funding.
Disadvantages of Debts Financing
In reality, the disadvantage is considerable.
- You’ll have to give the investor a piece of your business in exchange for financing.
- Any time you make decisions that impact the business, you’ll have to share your income
- Also to consult with your new partners.
- The only way to get rid of investors is to buy them out,
- Although buy them is almost certainly be more costly than the money they gave you in the first place.
Debts Financing vs Equity Financing
A loan is the most common form of debt financing. Debt financing, unlike equity financing, allows a company to repay the money it receives plus interest. A loan (and debt financing in general) has the benefit of not requiring a corporation to hand over a portion of its ownership to shareholders. The lender has no leverage over the business’s activities as it uses debt financing. Your arrangement with the financial institution ends after you have paid back the loan. In most cases, the equity-financing process is regulated by laws enforced by a local or national securities regulator. This type of regulation is specifically intended to protect investors from dishonest operators who may collect funds from unsuspecting investors and then disappear with the funds.
Companies typically weigh the following three considerations when deciding whether to pursue debt or equity financing:
- What is the most convenient source of funding for the company?
- What is the cash flow of the company?
- How critical is it for the company’s principal owners to retain full control?
Hello everyone! This is Richard Daniels, a full-time passionate researcher & blogger. He holds a Ph.D. degree in Economics. He loves to write about economics, e-commerce, and business-related topics for students to assist them in their studies. That's the sole purpose of Business Study Notes.
Love my efforts? Don't forget to share this blog.