Companies typically have an alternative between raising capital through debt or equity financing. This decision usually varies as a function of the source of financing most easily available to the firm, its current cash flow, and the importance the firm’s principal owners place on retaining control of the firm. The debt-to-equity (D/E) ratio indicates the percentage of financing that is provided by debt and the percentage of financing that is provided by equity relative to each other.
Equity Financing:
Equity financing means the sale of company shares in order to raise capital. Purchasing the shares also gives the ownership rights of the company to the investor. It can also refer to the sale of all equity instruments, such as common stock, preferred shares, share warrants, etc. Equity financing is especially important for a company’s startup stage to finance plant, assets and initial operating expenses. Investors make profits by getting dividends or when their shares price increases. Equity financing may come from friends, family, professional investors, or an initial public offering (IPO).
The amount of equity financing that you hold may depend more upon your willingness to share the control of management than upon the investor’s appeal of the business. And by selling equity shares in your business, you are sacrificing some of your autonomy and management rights.
Sources of Equity Financing:
If the company is still private, then there are many sources that allow for equity financing from angel investors, crowdfunding platforms, venture capital firms, or corporate investors. Finally, shares can be sold to the public through an IPOs.
1. Angel Investor:
Angel investors are wealthy individuals who purchase stakes in businesses because they believe there is potential in those businesses to generate higher returns in the future. These individuals generally bring their business skills, experience, and connections to the table, which helps the company in the long term.
2. Crowdfunding platform:
It is a platform that allows a number of people in the public to invest in small amounts in the company. There are Members of the public who decide to invest in the companies because they believe in their ideas and hope to earn their money back with good returns in the future. Contributions from the public are totalled up to get a target total.
3. Venture Capital firms:
Venture capital firms are investors who take their money and invest it in companies that they feel will gain at a fast pace and will be featured in the stock exchange sometime in the future. They invest more money into businesses and are given a bigger stake in the company compared to an angel investor. The process is also called private equity financing.
4. Corporate investors:
Corporate investors are the big firms that invest in the private firms for offering them the much-needed capital. An investment, generally, is created to develop a strategic partnership between the two businesses.
5. Initial public offerings (IPOs):
Companies that are well-established can raise funding with an initial public offering (IPO). The IPO allows companies to raise funds by offering its shares to the public at large for trading in the capital markets.
Advantages of equity financing:
1. Less Liability:
No loan payback or any instalment, only you need to share the profit with the investors.
2. No credit problems anymore:
If you do not have a good credit-worthiness, even because of a bad credit history or for not having a financial track record, equity financing may be better than debt financing.
3. Learn and get from partners:
With equity financing, you will also be giving yourself an opportunity to unofficially partner with more sophisticated or experienced people or organizations. At times, these people are well-connected, and the business will benefit directly from knowledge and business connections within your lines of work.
Disadvantages of equity financing:
Share profit:
Your investors will expect – and deserve – a share of your profits. But it can be a fair trade if you are benefiting from their worth as a source of finance and/or their business expertise and experience.
Loss of control:
The price for equity financing and all the potential benefits that you can derive from it is that you have to share control of the company.
Potential conflict:
Co-ownership and the issues of having to work with others can create tension or even outright conflict because a different vision, management approach, or business approach is in place. Something that could be seriously taken into consideration.
Debt Financing:
Debt financing refers to the raising of finance by selling the debt instruments to investors. Debt financing contrasts with equity financing, which involves the issuance of stock to raise funds. Debit financing occurs when a firm issues fixed-income products, such as bills, notes, or bonds. While in the case of equity financing, the lenders gain stocks, debt financing has to be repaid. In particular, small and new companies do rely on debt financing in order to obtain resources that may help them grow.
Sources of Debt financing:
1. Term loans:
Term loans basically involve borrowing a sum of capital in one go from a bank or any such financial institution. The borrower has to repay it over a fixed time frame. It may have fixed or floating interest rates. Generally, these loans have regular monthly payments comprising principal and interest.
2. Business lines of credit:
A line of credit is a flexible loan which allows a business access to a certain amount of capital that can be drawn upon as needed. In other words, just like a credit card, businesses pay interest only on the amount of financing that they have actually borrowed. Lines of credit are also important tools for the management of cash, payment of short-term expenses related to operations, or unexpected costs.
3. Equipment financing:
Equipment financing is borrowing money with the express purpose of purchasing business-critical equipment; the equipment itself becomes the collateral pledged on the debt. Basically, an acquisition or lease lets a company acquire such machinery, vehicles, or technology that a business cannot operate without but cannot actually spend cash for immediately.
4. Trade credit:
Trade Credit This is a short-term financing through suppliers. It is when a company can buy something, then pay for it 30 or 60 days later. The nature of this type of financing is to help companies manage inventory and produce goods that will help them to attain cash flow to pay for the invoice.
5. Convertible Debt:
This is a hybrid kind of financing that combines debt as well as equity financing. Loans can be converted into equity shares in the future. A company may decide to issue a bond but provide the holder with the opportunity of switching from debt financing to equity financing later.
Advantages of debt financing:
1. Leverage:
The most important advantages of debt financing are that with a very small amount of money, a business can leverage it into a much greater amount, thus facilitating faster growth and debt payments can be tax-deductible.
2. Independence:
Debt financing also ensures that the business loses nothing in terms of ownership and control. Unlike equity financing, where one sells ownership stakes to the investor, the business owners do not have to sacrifice their control or decision-making power over the firm.
3. Relatively cheaper: Debt financing is relatively cheaper than equity financing. Equities investors can expect continued dividends and a share of the profits, which might cost more in the long run. The only way to extinguish this is through the reacquisition of shares.
4. Not a fixed obligation: Once the debt is repaid, that marks the end of the relationship between the firm and the lender, with no further obligations.
Disadvantages of debt financing:
1. Interest:
The key disadvantage of debt financing is that interest must be paid to the lenders. This means that what is paid will be higher than the amount borrowed.
2. Repayment:
Repayment on debt does not care about whether the business gets revenue. Its risk is especially high for smaller, newer businesses before a solid cash flow has developed.
3. Flexibility:
Excessive debt harms the balance sheet and several financial ratios of the business. This can make the venture appear less secure to investors and lenders; hence, the business might face costlier borrowing down the line. High levels of debt also limit the flexibility of the company, since much of its revenues will be spent paying back the debt.
4. Liability:
Even though your business limits your personal liability in case you are sued, some lenders of debt financing require you to stake your assets on themselves. In case you fail to repay your loan, your lender might seize your assets.
Conclusion:
A company can decide to go for debt financing or equity financing, as each of these methods has its own preferences on the choice of non-dilutive and dilutive financing. The answer to the question, which financing should a company choose, would depend on the type of capital structure, business being followed, and financial health of the company.
Further, it also depends upon the types of financing that you and your company have used with your company so far. If you are focusing more on the equity investments and built the companies based on the solid profits and revenue, then you are potentially ready for debt financing. If you are just starting, then your focus should be on equity capital.