Factors to consider when choose between Debt and Equity
August 29, 2019
Finance is the most essential part in running any business. It allows business to grow, to generate employment and to meet daily requirements in business. A dream of business is only convertible into reality when appropriate finance is available. It’s crucial that a company’s financing is aligned with and helps to deliver its strategic ambitions. Debt financing and private equity are two most important sources of financing any business.
Debt financing is a time-bound activity where the borrower needs to repay the loan along with interest at the end of the agreed period.
Equity financing is the process of raising capital through the sale of shares. Companies raise money because they might have a short-term need to pay bills or they might have a long-term goal and require funds to invest in their growth. By selling shares, they sell ownership in their company in return for cash.
Debt and Equity: Which one to choose?
Both debt and equity financing have pros and cons for all new business owners. The choice that is right for you will be very specific to your business.
- Income Generated: Income is the most important factor to consider while choosing between debt and equity. Income is both considered by lender and investor. If a company will not have sufficient income it will be difficult to repay the loan in future else another alternate is to go for private equity. It’s important to analyze the future numbers and accordingly should select the right option.
- Ownership: For smooth running of business debt is the better option than equity because if a company is going for private equity that means they are giving away some share of ownership to the investors. They will be involved in daily activities and will keep a check on it. While lenders will not try to involve in the management of the company. In debt financing once the loan is paid off the relationship with lender ceases. Investors continue to have a say in the company until they are bought out, the company is sold or goes public. How you finance the company has an impact on your independence as management.
- Financing cost: A certain price must be paid for the privilege of accessing funds when using either debt or equity. One benefit of debt financing is interest payments are usually tax-deductible. Even if interest rates rise, the cost is partially offset by the reduction in taxable income. Because payments on debt are required regardless of business revenue, the risk to lenders is much lower than it is to shareholders. Shareholders are only paid dividends if the business turns a profit, so there is a possibility the investment will fail to generate adequate returns. Due to this decreased risk of default, most debt financing options still carry a lower cost of capital than equity financing unless interest rates are particularly steep.
- Amount of Capital Required: The decision of choosing between debt and equity also depends on the amount of capital required. If a business is not looking for a huge amount debt financing should be a go to option but if business requires huge amount of money then looking for a private investors would be a more feasible option. Also, debt syndication is comparatively a less time taking process than private equity.
- Risks Involved: Both the source of financing involves the risk. Debt capital requires a business to make periodic payments to a lender. These payments might include interest, principal or both. If a company is unable to make these payments, it risks losing assets it pledged as collateral and might be forced into bankruptcy. If a business raises too much equity capital, it risks losing control of the company. Equity investors are typically entitled to vote on certain company matters. If you sell a large equity stake to one investor or a group of investors, they might try to influence the company in a way with which you don’t agree.
- Current Capital Structure: Although debt is attractive due to its cheap cost, its disadvantage is that interest has to be paid. If too much is borrowed then the company may not be able to meet interest and principal payments and liquidation may follow. The level of a company’s borrowings is usually measured by the capital gearing ratio (the ratio of debt finance to equity finance) and companies must ensure this does not become too high.
Both sources have their own pros and cons. If a startup is looking for a funding private equity can be recommended as the startup would not be able to fulfill the lenders requirement. Also a private investor will also help the business to grow by sharing their market experience and knowledge. But is a business is established they can look for debt funding because they would be able to align with the lender requirements and no control of the business will have to be share. So, it’s very important to consider to all the factors before choosing a source of finance and the decision should be aligned with the objective and success of the business.