Growing up, it has always been said that one can raise capital or finance businesses with personal savings, gifts, or loans from family and friends and this idea continues to persist in modern business, but probably in different forms or terminologies.
It is a known fact that for businesses to expand, it is prudent for business owners to tap into financial resources and use a variety of financial resources, generally divided into two categories, debt and equity.
Equity financing, simply put, is raising capital by selling shares in a company, that is, selling a stake in the property to raise funds for business purposes, and the buyers of the shares are called shareholders. . In addition to voting rights, shareholders benefit from ownership of the shares in the form of dividends and (hopefully) eventually sell the shares at a profit.
On the other hand, debt financing occurs when a company raises money for working capital or capital expenditures by selling bonds, bills, or promissory notes to individuals and / or institutional investors. In exchange for lending the money, individuals or institutions become creditors and are promised that the principal and interest on the debt will be repaid later.
Most companies use a combination of debt financing and equity financing, but the Accountant shares a perspective that can be seen as distinctive advantages of equity financing over debt financing. Chief among them is the fact that equity financing carries no repayment obligation and provides additional working capital that can be used to grow a company’s business.
Why opt for equity financing?
• Interest is considered a fixed cost that has the potential to raise a company’s breakeven point, and as such, high interest during difficult financial periods can increase the risk of bad debt. Overly leveraged entities (which have large amounts of debt compared to equity), for example, often struggle to grow due to the high cost of debt service.
• Equity financing does not impose any additional financial burden on the business, as there are no associated monthly payments required, so it is likely that a business will have more capital available to invest in growing the business.
• Regular cash flow is required for principal and interest payments and this can be difficult for companies with inadequate working capital or liquidity problems.
• Debt instruments are likely to come with clauses that contain restrictions on the company’s activities, preventing management from seeking alternative financing options and non-essential business opportunities.
• A lender is only entitled to repayment of the agreed principal of the loan plus interest and, to a large extent, has no direct claim on the future earnings of the business. If the business is successful, the owners get a larger share of the rewards than if they had sold the company’s debt to investors to finance growth.
• The higher the debt-to-equity ratio of a company, the riskier lenders and investors will consider. Consequently, a company is limited in the amount of debt it can take on.
• The business is often required to pledge business assets to lenders as collateral, and in some cases business owners are required to personally guarantee loan repayment.
• Based on company performance or cash flow, dividends to shareholders may be postponed, however, the same is not possible with debt instruments that require payment when due.
Adverse implications
Despite these merits, it will be so misleading to think that equity financing is 100% safe. Consider these
• Profit sharing, that is, investors expect and deserve a share of the profits made after a given financial year, as does the tax collector. Business managers who do not have an appetite for profit sharing will see this option as a bad decision. It could also be a valuable trade-off if the value of your financing is balanced with the right insight and experience; However, this is not always the case.
• There is a possible dilution of shareholding or loss of control, which is generally the price to pay for equity financing. A huge financial threat for startups.
• There is also the possibility of conflict because sometimes sharing ownership and having to work with others can create 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 must be followed to obtain equity financing, making the process cumbersome and time consuming.
• Unlike holders of debt instruments, holders of shares suffer more taxes, that is, both on dividends and on capital gains (in case of sale of shares)
Decision Cards: Some Possible Decision Factors for Equity Financing
• If your creditworthiness is an issue, this might be a better option.
• If you are more of an independent operator, you may be better off with a loan and not have to share decision making and control.
• Would you rather share ownership or 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 can opt for a loan, rather than having to share the profits.
It is always wise to consider the effects of your financing choice on your overall business strategy.
