This article has been written by Vaibhav Chauhan, pursuing the Diploma in Companies Act, Corporate Governance and SEBI Regulations from LawSikho.
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Do you know about the transaction of Flipkart and OLA which led to the fiasco because of equity financing? And what is the stand of Mr Yashraj Pal, CEO of Buzzinga Digital upon debt financing and equity financing?
Now, if you have been involved in the business for such a long time or if the business has just started like start-ups, you would require an influx of extra capital for the growth of the business, its expansion and other urgent requirements. Therefore, in order to satisfy the needs of capital business owners have two choices that are equity financing and debt financing in order to meet the requirements of the funds. But, what option will meet your need for capital? And what all factors need to be considered for the same?
The present article firstly introduces both the term Debt financing and Equity financing in order to establish the base, for understanding the technicalities involved in the concept along with each type of finances and how it works.
This article also discusses the pros and cons of debt and equity financing and provides the snapshot of what among the two would be the best option for business along with the practical examples of transactions related to Flipkart and OLA. Also, the point of view of some key players of the market is also discussed to provide a better understanding of the concept.
By understanding how equity financing and debt financing differ from each other and what all factors to be considered before making the decision, you will be able to make the well-informed decision which would not lead to the fiasco.
Debt financing is the thing which is very much prevalent in businesses and early age start-ups because whenever someone thinks of financing, debt financing is an instant option which crosses the minds of the ones at first instance. Speaking, fundamentally, debt financing refers to the raising of funds via debt and the term debt means borrowing where the lender will provide you with the capital or say funds which you require for your business or start-up. Often, the borrowed amount that is debt has to be repaid after the specific interval of time with interest. As there is a saying “There are no free lunches in life”, the same way there would be no interest-free debt in life. However, this imposition of interest may differ upon the source from where you are obtaining debt. For example: if you borrow the money from your business circle or say a friend there might be a possibility that they may charge interest upon the debt.
Moving further, do you know how debt financing works?
It is not that hard to understand the working of debt financing. Practically, one usually applies to receive money from the lender, this could be a bank, credit union, an alternative lender or any individual from your business circle that will make capital available for your business. At this point when aforementioned lenders are considering you to provide with the debt they will determine your qualification for the raising of that debt on the following factors:
- Annual Revenue of your company;
- Market standing of your business or worth in idea if it’s a start-up;
- Personal credit rating or say the capability to repay;
- Prevalent business transactions; and
- Creditworthiness of the business.
Above mentioned factors are not exhaustive but they are usually considered in the general practice of debt financing. So, the lender may consider any one of the above or combination of any of the above-provided factors or any of the additional factors as per his examination to determine your accumulated borrowing amount along with rates and terms of the loan.
It is pertinent to mention here that at the time of raising debt finance it could be secured by the collateral security and the lenders usually consider the business assets free from charge to be used as the collateral for the debt or the personal property of the individual equal to the debt raised may also be taken into consideration. Moreover, if you default in repaying the debt/borrowed amount including the interest charged within the specified time limit the lender has got the right to seize the collateral as mentioned above in order to pay off the debt. In simple terms, collateral is created for the security of the borrowed amount. Whilst, you have provided collateral for the loan, the lender does not hold a stake in your business w.r.t. the debt. This is the point of difference in broader contour between the equity and debt financing which will be dealt with further in this article.
Types Of Debt Financing
After mentioning what debt financing is, it is necessary to provide a snapshot of the types of debts financing and the selection among the types of debt financing depending upon the requirement or need of the business. The types are provided below:
- As mentioned in this article above, whenever someone wants money for raising finance the term loan will likely cross one’s mind. Further, the loan is further classified into the long term and short term loan. The long term loan has to be paid after several years which is a long duration in comparison to the short term loan. It is usually taken from banks through Small Business Administration (hereinafter referred to as the SBA) as this comes in the priority for the business owners and SBA is provided on the lower interest rates by the banks for the longer time period along with strict terms and conditions are present to get approval for the SBA. The long term loan is required for big business requirements such as establishing the project, building, big business purchases etc. Also, it is pertinent to mention here that a long term loan would be granted only when the business is having good market standing with appropriate legal credit worthiness etc.
- Further, a short term loan as the name suggests is for a shorter period with less credit/loan. This option is best for serving the smaller purpose or the short term capital requirement for example short term immediate expenses, supplies, inventory etc.
Lines of Credit
- Lines of credit are the viable option for those who require a loan or say capital at the regular interval of time and do not want to take the entire amount of the loan which is usually issued with the banks because of their minimum limit cap for granting the loan. So, when the borrower applies for the loan amount and its gets approved on the mentioned terms and condition he can take the required amount from the total amount, meaning thereby that there is no compulsion to take the entire loan amount in one single go and after taking the required amount the remaining amount will stay with the bank only. Further, the interest will be imposed on that amount which the borrower has taken out and not upon the entire amount due to which one can easily get rid of the huge loan EMI’s with burdensome interest.
- This type charges a lower rate of interest in comparison to the other options for raising loans and it can also be classified as the credit card where you do not have to use the entire credit card limit. After using the line of credit the withdrawn amount will be sent to your bank account where the borrower can access that amount.
- For example, the bank has sanctioned INR 60,000 to you based on your Letter of Credit application and from the approved amount you have taken out INR 20,000 as per your requirement. In such an instance, you have to pay the interest amount for only INR 20,000 and not for the total amount.
- Also, lines of credit are generally used for emergency purposes.
Business Credit Cards
- A business credit card works like Line of credits, as in business credit cards you can make the transactions with the swipe anywhere credit cards are allowed to swipe or the place is accepting payments through credit card. After that, one has to repay this amount with interest because it is a type of small loan only which is provided to you on credit at the time of emergency and after the repayment of such credit amount you can again withdraw the amount from such business credit card but remaining within the limit of transaction or say the credit card. In our day to day life, we usually use a credit card for making small payments of our purchases, payment of fees or unexpected expenses etc.
- Thus, the above provided are some of the types of debt financing which acts as a blessing in case of the dire need of businesses or for any other capital requirement.
Advantages and disadvantages of debt financing
After considering the types of debt financing the advantages and disadvantages is provided below for better understanding:
- Retaining business ownership: When you are opting for debt financing, you retain your ownership meaning there by you are in complete control of your business/company. In simple words when you raise funds by debt financing you don’t have to share the profits of the business with the investor.
- Availability of the various options: When you choose lines of credit for the required funds it provides the various options to use the debt for any situation as per the requirement.
- Arrangement for future: In debt financing you clearly know for how long you have to repay the debt with interest due to which you can turn the table of time in your favour by strategizing the arrangement of future for the usage of funds in working capital or for the growth of the company/business effectively.
- Availability: Debt is usually available for every business and company irrespective of its size, time in business etc. but creditors usually consider 5 C’s of the credit that is character, credit, capacity to repay, collateral and conditions.
- Payment of Interest and other Fees: In debt financing the borrowers with great credit worthiness and it qualifies all 5C’s as mentioned above it still has to pay the interest or/and fees on the debt amount. Also, the businesses with greater risks in repaying the debt might have to pay the huge interest because of the probability of getting that debt converted into bad debt.
- Market Standing: As the name says DEBT-loan, it portrays the image or the market standing of the business that it is into risk pertaining to the lenders and investors and it might also affect the business Debt-to-Equity Ratio which is usually seen by the investors at the time of investing into any of the business or company.
- Risk: Debt financing always carries risk with itself that’s why it is usually suggested to see whether you are willing to take such risk and the risk occurs when you make default in making the payment of debt on specified time and interest gets on running like anything which somewhere down the line shred the assets of ones business because the same is kept as collateral to debt raised and would soon be undertaken by the lender or the investor to get back his money.
- Requirements for raising the debt/borrowing: debt financing provides with the several options to raise the same but the borrower has to meet the specific requirements to get that amount because the lender or the investor usually put certain conditions like 5C’s as mentioned aforesaid and sometimes it is difficult to meet those requirements.
Now coming on to the concept of equity financing as I have mentioned in the initial paragraph that it is different from debt financing because in this case lender or say the investor will provide with the capital in exchange of the shares in the company, meaning thereby ownership stakes will be provided to such investor in return of the capital provided in the company.
Thus, equity financing business owners do not have to pay through regular instalments with interest but share in the profit of the company will be provided to the investor. Also, it is pertinent to mention here that in practical business scenarios the share profit would only be provided when the company will make the profit in its ordinary course of business. Further, the investor will also exercise control in the company to the extent he invested in the company and the investor will also be involved in the decision-making process of the company.
For the purpose of more clear understanding the example is provided below:
If Mr A wants capital for his business say amounting to Rupees 5 lakhs and if Mr B an investor is willing to invest in Mr A’s business with that required amount and in return of providing this capital Mr B will be provided with the shares of the company of INR 100 each meaning thereby ownership up to some extent is provided to Mr B in the company because of the investment. Thus, this investment of Mr B in Mr A’s business and providing ownership to Mr B in the company is known as equity financing.
Types Of Equity Financing
Before considering the comparison between debt financing and equity financing let’s consider the types of equity financing. The types of equity financing are provided below:
Angel Investor and Venture Capitalists
- These types are very much prevalent for raising investment by start-ups with prospective to grow rapidly but require finances to do the same, in other words, start-ups having the capability to grow in the market with impeccable vision usually require investment to prove or say acquire the same.
- Angel Investors and Venture Capitalists (hereinafter referred to as the VC) are experienced in predicting the value and capability of the start-ups and businesses because they invest on a daily basis on the risk of earning that much return which they would have expected from their investment. That’s why Angel Investors and VC’s don’t invest in any project without considering the relevant factors of their growth, vision, operations and future perspective of the business or the project.
- In the practical world, Angel investors are usually connected with the owners of business owners and angel investors do not invest in start-ups easily because of the higher risk but VC’s are the private investors who are ready to invest in the start-ups with high growth graphs and vision.
- Practically if a borrower wants that VC or angel investor to invest in his company or say business he needs to have noticeable market standing, creditworthiness and vision with the working of the business which will make the angel investor, as well as the VC, invest in the business. Further, crowdfunding is the version of equity financing in which the businesses usually sell a very small part of the shares to many investors through a crowdfunding platform.
- It is pertinent to mention here that it requires huge marketing efforts, online gigs and very thorough base work to create the platform for the equity crowd funding and in practicality, the use of the internet, social media platform like LinkedIn and some other dedicated websites for this work only will help you create that platform with impact including this will increase your business outreach for this purpose and this platform would provide you with the opportunity to make the worthy pitch to the public.
Family and other Relatives
Your relations and family members could turn out to be your saviour for the equity investments because these are the ones who know about you in and out your vision about the business, efforts you are making the business grow day and night. But, when a family comes into the business it cannot be called purely business-related but raising investment from the family or relatives will make it an informal relationship between you and the family or relatives. One point which you should always remember is you meet short but emergency expenses with this source but if the requirement is big or say huge then one should for the aforementioned ways.
These institutions include an insurance company, mutual funds company like Zerodha, LIC are the key investors in the private segment and they would be of very much help for the long term financing.
In this gigantic corporate world, it’s all about networking, strategy and risk calculated decision making and big companies usually purchase the shares of the newly established companies in the corporate pool, so that they can establish the network which will provide them fruit in the long run. Also, this investment will provide them with a valuable return if the business performs well in near future.
Advantages And Disadvantages Of Equity Financing
The advantages and disadvantages of equity financing is provided below:
- Favourable for newly set up business: Equity financing is considered as the best option for the newly introduced business because you can also bring some expertise with that but you may also meet the requirements to raise the debt financing but that would be available with the lower limits in comparison to the equity.
- No Interest or fees: Like in debt financing one have to take care of interest and/or fees upon the raised debt and this interest usually act as huge pressure on their heads but in equity financing you do not have to worry about the interest or payment of fees and this provide you the added advantage because you can invest more money in your business now.
- Risk taken by the investors: Practically, in equity financing it’s the investors who will take the fall by investing in the new start-ups and even with the business with settled market standing because they only consider the interest from the capability of your product and the performance of the business.
- Providing the ownership: the foremost disadvantage of equity financing is the sharing of the ownership with the investors which implies sharing of the profits of the business/ company with the investors. Sharing of the ownership implies that you are not only reducing the profit of share for you but also the investor will exercise the control in the business up to the extent of the investment made by him along with power of decision making regarding the business operations.
- Tracking the investors is quite difficult: Second, disadvantage in equity financing is that searching for the interested investor is very difficult and exhausts most of the crucial time of the business and the companies because it take quality of time to make pitches according to the different investors, backend work for the preparation of that pitch etc. and if you need money urgently without making the big efforts then you should not go for the equity financing. It’s a big NO for equity financing if the need is very urgent and the investor is not there.
Debt Financing Vs Equity Financing
Now, after discussing the advantages and disadvantages of debt financing and equity financing, under this head I’ll be providing the comparison between the debt and equity financing relying upon the thoughts of big market players who themselves have experienced this need for financial crunch and are now running successful businesses.
AnBac Advisors, founder and CEO Mr Anuj Bali, runs the premier chartered accountancy firm based in New Delhi and they have provided legal and fund raising consultancy services to corporates, firms, Start-Ups, government ties etc. Mr Anuj Bali is of the view that debt financing is ultimate funds if it is used for the working capital requirements means that capital of the business which is required to be used in the day to day operations, and for more simplification it can be calculated as the current assets- current liabilities. He further stated that equity financing would fetch you sense when it is for the big projects, new technology projects, innovation etc. and why it is useful is a very practical answer because it is for the longer time period in comparison to the debt. Further, take the note of this thing identifying the needs of the business and its current situation will surely help you in exploring the wiser, effective and efficient choices.
CEO of Buzzinga Digital, Mumbai, Mr Yashraj Vakil, who provides digital marketing services to help the business and start-ups to make their visibility on social media and for various other purposes is of the view that it majorly depends upon the business to decide which option to go for either debt or equity financing. He simply provides that debt financing would be required by those business founders who do not want to share the ownership of their business with someone else and equity financing is best when you are not definite about the success of the business. But, always keep this in your mind that one can always take the share of equity back by raising the debt financing and in practical world ownership is shared during the initial stage of their businesses.
To understand the view of Mr Yashraj let’s consider the example of two big players that is Flipkart and OLA. To see the backdrop of equity financing one consider the example of Filpkart founders that is Mr Sachin Bansal and Mr Binny Bansal because Flipkart took the hit when Walmart is increasing its stake in the company which means taking the ownership. Moreover, Ola is in the same situation as SoftBank was acquiring when the funds were raised through equity financing. Further, in this respect Flipkart’s founders has to step down to save its business and Mr Bhavish Agarwal, Co-Founder, Ola also have to cancel the deal amounting to US$ 1.1 billion with the Japanese Walmart and have also ensured that control of the founder in the company remained protected from the external investors. We can also say these deals are the failure for both Flipkart and Ola because of wrong and uncalculated decision making.
Now, after considering the aforesaid examples and the thoughts of eminent personalities of the corporate world according to me comparison of debt and equity is turned out to be the example of comparing apples with oranges. Why, I’m saying it’s like Apple and Oranges because both of them held different values for the operating business and the requirement of both depends upon the need of the business, size of the capital, emergency and specially examination of the need with respect to nature of debt and equity. Equity is more of used when a company wants to grow with the upwards graph in order to beat the competition in the market as fast as possible. But at the same point one has ownership in the business.
On the other hand Debt financing is used for working capital requirements as aforementioned. If you carefully analyse the situation between debt and equity financing one can easily get his sight on the point that if business is exhausting its equity for day to day operations that is working capital requirements then business is losing its vital cash flow which can effectively be used for the growth of the business.
In the light of aforementioned reasoning we cannot say one is more preferred over the other because it totally depends upon the way they are used by the business.
What is the best option?
Now, after the clarity upon basics of the debt and equity financing and also in the light of above mentioned statements, reasons provided by the big market players along with the practical case situation, it’s time to come on to the decision what is the best option?
Further, for the purpose of clarity of the business I have provided some crucial points or say the boxes which one has to tick mark in the checklist whenever opting to go for equity or debt financing:
Checklist for Equity Financing
- If you are looking the growth of the business;
- If you have need for capital that could not be fulfilled with the debt financing;
- You are ready to give up some ownership control in your business but first analyse upon the case of Filpkart and Ola as provided above;
- Need for capital for urgent and for longer term.
Checklist for the Debt Financing
- When you have small capital need;
- When you want to safeguard the control of founder in the business;
- When you are ready to bear the risk to lose the business assets of unable to repay the debt in the specified time limit along with interest;
- Need for finance is quick.
Therefore, relying upon the afore provided checklist and considering the thoughts of players who are presently operating in the business you can easily get all the answers not only about what? But also for why? When? Where? And Who? In the debt and equity financing.
Note: Above list is not exhaustive; it is solely based upon the author’s personal views and research.
At last, it is pertinent to consider the decision of raising the capital for business in the spirit of pros and cons of debt and equity financing. You should have a clear understanding about which among the two would be the best option as per the requirement of the business before taking one step ahead and by this way you can save your business from creating fiascoes like OLA and Flipkart as mentioned above.
Furthermore, practically you should appoint the legal counsel for raising the finance who is well versed with the nuances of the debt and equity financing and have also done with the transaction in this respect. Also, you should also have the basic knowledge pertaining to the same.
Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skill.