Growing up it has always been said that one can raise capital or finance business with either its personal savings, gifts or loans from family and friends and this idea continue to persist in modern business but probably in different forms or terminologies.
It is a known fact that, for businesses to expand, it’s prudent that business owners tap financial resources and a variety of financial resources can be utilized, generally broken into two categories, debt and equity.
Equity financing, simply put is raising capital through the sale of shares in an enterprise i.e. the sale of an ownership interest to raise funds for business purposes with the purchasers of the shares being referred as shareholders. In addition to voting rights, shareholders benefit from share ownership in the form of dividends and (hopefully) eventually selling the shares at a profit.
Debt financing on the other hand occurs when a firm raises money for working capital or capital expenditures by selling bonds, bills or notes to individuals and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise the principal and interest on the debt will be repaid, later.
Most companies use a combination of debt and equity financing, but the Accountant shares a perspective which can be considered as distinct advantages of equity financing over debt financing. Principal among them are the fact that equity financing carries no repayment obligation and that it provides extra working capital that can be used to grow a company’s business.
Why opt for equity financing?
• Interest is considered a fixed cost which has the potential to raise a company’s break-even point and as such high interest during difficult financial periods can increase the risk of insolvency. Too highly leveraged (that have large amounts of debt as compared to equity) entities for instance often find it difficult to grow because of the high cost of servicing the debt.
• Equity financing does not place any additional financial burden on the company as there are no required monthly payments associated with it, hence a company is likely to have more capital available to invest in growing the business.
• Periodic cash flow is required for both principal and interest payments and this may be difficult for companies with inadequate working capital or liquidity challenges.
• Debt instruments are likely to come with clauses which contains restrictions on the company’s activities, preventing management from pursuing alternative financing options and non-core business opportunities
• A lender is entitled only to repayment of the agreed upon principal of the loan plus interest, and has to a large extent no direct claim on future profits of the business. If the company is successful, the owners reap a larger portion of the rewards than they would if they had sold debt in the company to investors in order to finance the growth.
• The larger a company’s debt-to-equity ratio, the riskier the company is considered by lenders and investors. Accordingly, a business is limited as to the amount of debt it can carry.
• The company is usually required to pledge assets of the company to the lenders as collateral, and owners of the company are in some cases required to personally guarantee repayment of loan.
• Based on company performance or cash flow, dividends to shareholders could be postpone, however, same is not possible with debt instruments which requires payment as and when they fall due.
Despite these merits, it will be so misleading to think that equity financing is 100% safe. Consider these
• Profit sharing i.e. investors expect and deserve a portion of profit gained after any given financial year just like the tax man. Business managers who do not have the appetite to share profits will see this option as a bad decision. It could also be a worthwhile trade-off if value of their financing is balanced with the right acumen and experience, however, this is not always the case.
• There is a potential dilution of shareholding or loss of control, which is generally the price to pay for equity financing. A major financing threat to start-ups.
• There is also the potential for conflict because sometimes sharing ownership and having to work with others could lead to some tension and even conflict if there are differences in vision, management style and ways of running the business.
• There are several industry and regulatory procedures that will need to be adhered to in raising equity finance which makes the process cumbersome and time consuming.
• Unlike debt instruments holders, equity holders suffer more tax i.e. on both dividends and capital gains (in case of disposal of shares)
Decision Cards – Some Possible decision factors for equity financing
• If your creditworthiness is an issue, this could be a better option.
• If you’re more of an independent solo operator, you might be better off with a loan and not have to share decision-making and control.
• Would you rather share ownership/equity than have to repay a bank loan?
• Are you comfortable sharing decision making with equity partners?
• If you are confident that the business could generate a healthy profit, you might opt for a loan, rather than have to share profits.
It is always prudent to consider the effects of financing choice on overall business strategy.