Debt and Equity finance are the most common ways of raising capital for a Business. These methods play crucial roles in the financing of a Company. Each one has different advantages and disadvantages, meaning one may be more or less suited for use under certain circumstances and certain market conditions.
Raising funds through debt finance means borrowing money from sources external to the Company, such as banks or other financial institutions. It works in the following way:
- Loan or bond issue: The Business borrows a specific amount of money from a bank or financial institution following an agreement over the loan term, interest, repayment sums and amount.
- Interest payments: The Business pays back the borrowed sum in increments, alongside interest on the borrowed amount.
- Principal repayment: Finally, the Business repays the entire borrowed amount, and the loan is discharged.
Advantages of Debt Finance:
- Tax deductibility: Interest payments can be tax deductible, reducing the overall cost of the borrowing.
- Retained Control: The shareholders of the company maintain control of the operations and decision making.
- Simple financial planning: If the loan is on fixed interest terms, it can mean that with a repayment schedule, long term financial planning and budgeting can be made simple.
Disadvantages of Debt Finance:
- Interest Costs: In order to be able to borrow, the banks or financial institutions will require the business to pay interest on top of the payment. In the current economic climate, with Bank of England Interest rates at 5.25%, these interest costs can be substantial.
- Risk of Default: Should the Business fail to repay an instalment, it may be that the full amount becomes due. As a right to demand a repayment of the full amount plus all accrued unpaid interest (and any other amounts due) by the borrower in the event of default, is not considered a penalty under English law, is a very real possibility.
- Leverage risk: High debt levels can strain the financial health of the Business. As homogeneous with all leveraged risk, if the business goes well, then all is well. However if the Business goes badly, rather than simply ‘going broke’ the Business has actually gone further than that and gone negative.
What is Equity Financing?
Equity financing consists of selling ownership of the Company to investors. This is done through the sale of shares in the Company, done in the following way:
- Equity issuance: The Company sells shares (typically of common or preferential) to investors.
- No Repayment: The Company receives cash in return for the shares. This raises capital for the Company.
- Shareholders: The purchasers of the shares are now shareholders of the company and have the rights associated with the shares they purchased (typically voting and/or potential dividends)
Advantages of Equity finance:
- No repayment pressure: As there is no loan to be repaid, financial stress on the company is eased.
- Shared risk: The purchasers of the Company share the risk, as without the Company doing well, their equity is worthless.
- Expertise and Networks: By introducing equity investors to the Company it can mean that expertise and connections are introduced, which can help the Company thrive.
Disadvantages of Equity finance:
- Dilution of ownership and subsequent loss of control: By selling shares in the Company, the overall portion of ownership has been diluted, meaning that the original owners of the Company own less of the Company they set up. Alongside that, these new shareholders will want a say in the company decision making, potentially further constricting the owners.
- Potential Dividend expectation: If the profits of the Company increase, the Shareholders will potentially demand dividends, as a way of returning their original investment.
There is no clear answer as to which is better, as each method of raising capital may be more suitable for different situations.
Debt Financing can be more suitable for short term needs (e.g working capital) and for established Businesses who can be sure they can meet the financial commitments.
Equity Financing can be more suited for startups or growth-oriented Companies where cash flow may not be certain or expected for a while.
