Debt financing is the process of raising capital through the sale of fixed-income products such as bonds, bills, or notes to investors (1). It is money borrowed that you pay back with interest within an agreed-upon period.
The most common examples of debt financing include bank loans, overdrafts, mortgages.
Advantages of Debt Financing
Maintaining ownership: The institution or individual lending you the money has no say in how you run the business. The business relationship ends once the loan is repaid.
Tax deductions: The loan interest expense is tax-deductible, effectively reducing your net obligation
Retaining profits: There is no sharing with the lending party.
Disadvantages of Debt Financing
Accessibility: Debt financing is only available for businesses that meet the qualification requirements, such as a good enough credit rating.
Collateral: By providing collateral, you put some of the business assets at potential risk.
Repayments: The agreed-upon installments have to be repaid on specific dates without fail. Businesses with unpredictable cash flows might have difficulties making repayments. Repayments can also adversely affect the company’s cash flow.
Credit rating: Failure to make the repayments required can affect the company’s credit rating, which will affect future credit applications.
Equity Financing
Equity financing is the process of raising capital through the sale of shares (2). It involves selling a portion of the company to investors, who purchase ownership rights to the company.
A private company raises equity financing from angel investors, crowdfunding platforms, corporate investors, or venture capital firms. For example, an angel investor can provide the needed capital to finance growth for a 30 – 50% stake in the company. When a company eventually goes public, funds are raised through the sale of shares in an IPO.
Advantages of Equity Financing
No repayment obligation: The business doesn’t have to make monthly loan repayments, which is particularly crucial if the company doesn’t initially generate profits.
Access to extra business resources and expertise: Some investors provide invaluable contributions such as access to wider networks, expertise, and other sources of capital.
An alternative source of funding that is collateral-free: Equity financing provides an alternative financing source for businesses that don’t qualify for large bank loans. It also does not require a pledge of collateral. Assets purchased with equity financing can be used to secure future long-term debt.
Disadvantages of Equity Financing
Dilution of ownership and operational control: Investors have financial and governance rights that dilute ownership and control of a company and increase management oversight (3).
Share profits: Profits are shared amongst the shareholders. The legal restrictions that govern the use of equity financing determine the dividend returns received by each investor.
Lack of tax shields: Distributed dividends are not tax-deductible, as is the case with the interest expense for debt financing.
What is the best long-term liability financing for your business?
Almost all businesses, including start-ups, need to bring in outside funds at some point to fuel growth.
Equity financing is vital during a company’s startup stage when finances are necessary to acquire assets and cover the initial operating expenses. It is ideal when:
Business creditworthiness is an issue.
You don’t mind sharing your decision-making and control rights.
You would rather share ownership/equity than repay a bank loan.
You don’t mind sharing profits.
Debt financing is best if you:
Need to retain full ownership and control.
Are comfortable making monthly repayments
Qualify for debt financing.
Have collateral to use, and you are comfortable using it.
In the long run, equity financing is considered more costly because investors incur a high risk when funding a company and expect a higher return to counter the risk.
References used to write this article – Debt and Equity Financing
Chen, J. (n.d.). Debt Financing. Investopedia. (URL)
Corporate Finance Institute. (2020, August 13). Equity Financing. (URL)
Nordmeyer, B. (2019, August 8). Advantages & Disadvantages of Equity Capital. Finance – Zacks. (URL)
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Principal among them is that equity financing carries no repayment obligation and provides extra working capital that can be used to grow a business. Debt financing on the other hand does not require giving up a portion of ownership. Companies usually have a choice as to whether to seek debt or equity financing.
Debt financing means you're borrowing money from an outside source and promising to pay it back with interest by a set date in the future. Equity financing means someone is putting money or assets into the business in exchange for some percentage of ownership.
Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders' expected returns are lower than those of equity investors (shareholders). The risk and potential returns of Debt are both lower.
What is the difference between debt financing and equity financing? Equity financing involves selling shares of ownership in the company while debt financing does not.
There are no repayment obligations. There is no additional financial burden. The company may gain access to savvy investors with expertise and connections. Company health can improve by decreasing debt-to-equity ratio and credit score.
A strong advantage of debt financing is the tax deductions. Classified as a business expense, the principal and interest payment on that debt may be deducted from your business income taxes.
Because equity financing is a greater risk to the investor than debt financing is to the lender, debt financing is often less costly than equity financing. The main disadvantage of debt financing is that interest must be paid to lenders, which means that the amount paid will exceed the amount borrowed.
The advantages of debt financing include lower interest rates, tax deductibility, and flexible repayment terms. The disadvantages of debt financing include the potential for personal liability, higher interest rates, and the need to collateralize the loan.
Debt finance is money provided by an external lender, such as a bank.Equity finance provides funding in exchange for part ownership of your business, such as selling shares to investors. Both have pros and cons, so it's important to choose the right one for your business.
Debt finance requires no equity dilution, but the business must “pay” for this benefit via interest on top of the initial sum. Equity finance doesn't require the payment of any interest, but it does mean sacrificing a stake in the business and ultimately a share of future profits.
"Debt" involves borrowing money to be repaid, plus interest, while "equity" involves raising money by selling interests in the company. Essentially you will have to decide whether you want to pay back a loan or give shareholders stock in your company.
In conclusion, the three most common reasons for financial failure are lack of financial planning, ineffective cost management, and insufficient market research. Firms that proactively address these issues increase their chances of achieving and maintaining financial stability.
The main advantage of debt finance is the fact that you retain control of the business and don't lose any equity in the company. This means that you won't need to worry about being sidelined or having decisions taken out of your hands. Another key benefit is the fact that it's time-limited.
Reasons why companies might elect to use debt rather than equity financing include: A loan does not provide an ownership stake and, so, does not cause dilution to the owners' equity position in the business. Debt can be a less expensive source of growth capital if the Company is growing at a high rate.
Because equity financing is a greater risk to the investor than debt financing is to the lender, debt financing is often less costly than equity financing. The main disadvantage of debt financing is that interest must be paid to lenders, which means that the amount paid will exceed the amount borrowed.
The advantages of debt financing include lower interest rates, tax deductibility, and flexible repayment terms. The disadvantages of debt financing include the potential for personal liability, higher interest rates, and the need to collateralize the loan.
A dividend is guaranteed in the event of a loss. Investors will get a dividend if there is a profit once the board of directors suggests one. Investing in equity shares is riskier than other investments, such as loans. Funding decisions are made based on an investor's trust in the business.
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