Companies often choose between stock and debt financing when seeking to raise funds. Debt and equity finance are typically used together, although each has benefits. Equity financing has several advantages, chief among them being that it does not need repayment and may be utilized to increase a company's operating capital.

Debt and equity are the two main types of funding available to businesses. The firm's cash flow, the source of finance it has the most access to, and the importance the major owners place on preserving control of the Company are all factors that should be taken into account when making this decision.

Equity Financing

When a business needs money, it can raise it by selling a stake in the firm to investors. For instance, the owner of Company ABC may look for investors to finance the Company's growth. The proprietor sells 10% of the business to a financier in exchange for cash. Now that investor gets a 10% stake in the Company and a vote in all central policy and management decisions.

The primary benefit of equity financing is that there is no need to make repayments. Owners want their businesses to succeed so they can pay off their equity investors, but they'd like not to worry about making regular payments or paying interest.

Debt Financing

Borrowing money and then paying it back with interest is called debt finance. A loan is the most typical kind of debt finance. The terms of its debt funding might limit a company's ability to pursue prospects outside its primary industry. When evaluating a company's financial health, creditors give more weight to a low debt-to-equity ratio.

It's hard to list all of how debt financing benefits a business. First of all, the lender is powerless over your Company. When the loan is repaid, communication between you and the lender stops. The interest you pay is also deductible from your income1. Finally, because loan payments are fixed, it's simple to plan for upcoming costs.

Equity vs. Debt Financing: An Example

It has been determined that Company ABC must construct more manufacturing facilities and upgrade existing ones with state-of-the-art machinery to meet rising demand. It estimates it needs to raise $50 million in funding to support its expansion.

Company ABC has decided to raise the necessary funds through stock and loan financing. It raises $20 million from an undisclosed investor in exchange for a 15% share in the Company, which is the equity financing component. Debt funding consists of a $30,000,000 bank loan at 3% interest. There is a three-year repayment period for the loan.

The outcomes of the preceding example could have been any of a wide variety of permutations. If Company ABC elected to obtain cash through equity financing alone, for instance, its current owners would have to relinquish a greater percentage of the business, lowering their potential earnings and influence.

Why Choose Debt Over Equity Financing?

If a business is unwilling to give up any ownership stake, it may prefer debt financing over equity financing. If a company is confident in its finances, it will not want to give up the earnings it must distribute to shareholders by issuing more shares of stock.

Do Interest Costs Outweigh The Benefits of Investing in Debt?

Debt may be less expensive than equity, but this primarily depends on your firm's nature and performance. If you're not making money and you go out of business, the cost of your equity financing will be zero. There is still the need to repay the principal and interest on a debt-financed small company loan, even if operations are loss-making.

Here, the expense of borrowing money via debt is increased. It's possible that paying out millions to shareholders would be more expensive than keeping the ownership and paying down the loan. Every predicament is unique.

Is Debt or Equity Financing Riskier?

All of it is up in the air. When you are not making a profit, debt financing might be more precarious because of the loan pressure from your lenders. However, equity financing might be dangerous if your investors want a significant return on their investment, as they usually do. They may try to bargain for cheaper shares or sell if unsatisfied.

The Verdict

Corporations can raise money through debt and equity financing. Which one is best for your Company will rely on its specific objectives, risk appetite, and desire for management. Startups often go to equity funding, while more established organizations and those with a strong credit history and a risk tolerance may consider more conventional debt financing options like small business loans.