If a business seeks to raise capital for its needs, it typically has two financing options: equity and debt. Debt financing involves borrowing money, whereas equity financing involves selling a portion of the company’s equity.
What Is Equity Financing?
Equity financing involves raising capital through the sale of company shares. When a company sells shares, it effectively sells ownership in its company in exchange for cash. Companies may raise money to meet a short-term need, such as paying bills or fulfilling a long-term goal, like investing in future growth.
How does Equity Financing work?
The equity financing process involves the sale of a company’s stock in exchange for cash. The proportion to be sold will depend on your company’s investment and the value of your business at the time of financing. With the growth of your business, the value of the investor’s stake will also increase.
There are multiple ways for businesses to obtain equity financing, including business angels, crowdfunding, and venture capitalists (VCs). For a startup to grow into a successful company, it will require several rounds of equity financing. Since startups attract different types of investors at various stages of their development, they may utilize different equity instruments to finance their operations.
What Is Debt Financing?
Debt financing involves borrowing money to finance working capital, acquire specific assets, or perform other operations. You are taking out a loan from an individual or a company and pledging to repay it with interest. Credit cards, mortgages, and auto loans are all forms of debt financing.
How does Debt Financing work?
Debt financing can take many different forms. In general, there are three main methods of debt financing:
1. Business term loans:
Here, you borrow money from a lender, receive a lump sum upfront, and pay it back with interest for a specified period. These loans may be secured or unsecured, also known as traditional term loans or installment loans. Most of these loans have a set, fixed payment schedule.
2. Line of credit:
With a line of credit or revolving loan, you can access a credit line that you can use as needed. Unlike a term loan, you only pay interest on the funds you use, and once you have repaid what you have borrowed, your credit line resets.
3. Cash flow loans:
With cash flow loans, you receive an advance of funds based on the revenue you’re earning. Rather than paying back money over time with interest, you receive your remaining revenue, minus the lender’s fees, as your cash flow is received. Invoice financing and merchant cash advances can both be considered cash flow loans.
What Is The Difference Between Equity Financing and Debt Financing?
✅ A company that engages in equity financing is distinct from the one that engages in debt financing; the latter involves taking out a loan and repaying it over time with interest. In equity financing, a company sells ownership shares in return for funds.
✅ A loan is the most common type of debt financing. While equity financing does not require repayment, debt financing requires a company to repay the money it receives, plus interest. A loan (and debt financing in general) benefit is that a company does not have to give up a portion of its ownership.
✅ Under debt financing, the lender cannot control the company’s operations. Once you have repaid the loan, the relationship between you and the lender is over. In contrast, when companies raise capital by selling equity shares to investors, they must also share their profits and consult with these investors whenever they make decisions that affect the company.
What Are the Pros and Cons of Equity Financing?
✅ Equity financing has the advantage that it entails no extra financial burden on a company, and the owners are not obliged to repay the money.
✅ Equity financing has some disadvantages, including:
✔ You must share your profits with investors by giving them a percentage of your company.
✔ Investors must be consulted whenever you make decisions that will affect the company.
✔ If a company has sold equity to investors, the only way to remove them (and their stake in the business) is to repurchase their shares, which is a buy-out process. Nevertheless, repurchasing the shares will likely cost more than the money they initially gave you.
What Are the Pros and Cons of Debt Financing?
✅ Debt financing has some advantages, including:
✔ The lender does not control your business. When you repay the loan, your relationship with the lender ends.
✔ Your interest payments are tax-deductible.
✔ As loan payments do not fluctuate, it is easy to forecast expenses.
✅ Debt financing has the disadvantage that it is an expense that must be repaid regularly. In the long run, this could hinder your company’s ability to expand.
How To Choose Between Equity Financing and Debt Financing?
In determining whether to seek equity financing or debt financing, it is essential to consider the following factors:
✅ Credit History:
Lenders will typically review your credit history before approving a loan. If your credit history is unsatisfactory, you may need to apply for equity financing.
✅ Business Model:
Lending institutions typically prefer to lend to businesses with a proven business model, such as coffee shops and restaurants. Debt financing may be a good option if you wish to offer a superior product or service but do not want to reinvent the wheel entirely. You may also want to consider debt financing if you are interested in opening a franchise with an established brand. However, you are more likely to attract an investor’s interest than a lender if you plan to disrupt an industry using cutting-edge technology or a revolutionary idea.
✅ Risk Tolerance:
Lenders make money on the closing fees and the interest rate charged when you obtain debt financing. The term determines the monthly payment, interest rate, and amount of financing you receive. You are still responsible for repaying the loan with interest if your business fails, which means that you are at a higher risk of bankruptcy if this occurs.
However, equity financing differs, as the investor will invest capital in exchange for a percentage ownership interest in your company. This would equate to a predetermined number of shares. Investors hope that the value of those shares will increase over time, resulting in a substantial return on investment (ROI). In most cases, depending upon the terms you negotiate with an investor, the investor assumes the risk of non-payment if the business is unsuccessful, so you do not have to repay the investor.
✅ Assets To Be Acquired:
Lenders generally prefer to provide loans to businesses that use much of the loan proceeds to acquire tangible, depreciable assets. If the company fails, these assets can be liquidated, and the proceeds used to repay the loan (remember, if the business fails, you are still responsible for repaying the loan). You may be able to get your money even if you have no depreciable assets, but you might consider equity financing if this is the case.
✅ Collateral:
You should identify what personal assets you are willing and able to place as collateral and risk losing them if you obtain debt financing and the business does not succeed. If you still owe money after liquidating the business’s assets, your collateral is the next step in repaying the loan. You generally do not need collateral if you obtain equity financing unless you agree otherwise with the investor.
✅ Control Of The Business:
Obtaining equity financing usually requires that the investor has a say in the company’s goals and how to achieve them. Since they are part owners, you must discuss this with them. However, in debt financing, you are more likely to control your business goals and how you plan to achieve them since a lender does not own any equity in your company. As a factor not directly related to funding, you should consider how much control you are ready to give up as you launch and grow your business.
Conclusion:
Companies can raise capital either through debt financing or equity financing. Debt financing involves borrowing funds from a bank or other lenders. In addition to the principal amount of the loan, interest must also be repaid, which is the borrowing cost.
A business’s equity financing involves selling the company’s shares to investors. This may be achieved through private investors receiving a percentage of the company.
Each type of financing has pros and cons, and the right choice or mix will depend on the kind of business, its current financial condition, and its financing requirements.
The only viable option may be debt financing if your company serves a local market and does not require large-scale funding. Many successful startups often combine debt and equity financing to decrease the downside of each type.
Comments
Post a Comment