This article is written by Priya Singh, pursuing Diploma in General Corporate Practice: Transactions, Governance and Disputes from Lawsikho.
This article has been published by Abanti Bose.
Sima has been finding it difficult to commute to her office every day as her office is quite a distance from her house. Sima is now looking to purchase an apartment close to her workplace. She has been visiting at least two properties every day. Sima finally liked one of the houses she saw last week and is now ready to purchase it. The house costs 50 lakhs, and Sima has already paid 20 lakhs and plans to borrow the remaining 30 lakhs from the bank. If we look at Sima’s example, we can consider Sima’s house as an asset in which she invested 40% of her own money and 60% of the money she will borrow from the bank. Let’s compare this situation to running a business. A business in some way always requires capital and funds but it is quite possible that the business would not always have the required capital. In such a case the business owners or promoters have two options to raise funds. This could be in the form of debt or equity financing.
What do these terms actually mean?
In Sima’s example, we can say that her asset, which is her house, can be considered as your business which requires investment in the form of money. This money could be obtained through two options; one in the form of debt financing and the second in the form of equity. We can get an idea about debt financing through Sima’s example of getting a loan from the bank but to understand equity a deeper understanding is required.
Equity is when a business issues its stocks either to the public or to private investors. These investors ultimately become the shareholders of the company. For issuing stocks of the company, it is essential that the company dilutes its stocks or issues new shares on proper evaluation to the interested investors.
What is debt financing?
Debt finance is when you borrow money and pay it back with an interest over a set period. Bank loans, debentures, overdrafts, mortgages, bonds, and other forms of debt finance are the most frequent types of debt financing instruments.
Advantages of debt financing
Retention of ownership
Debt financing allows you to retain complete control over your business. As the business owner, you are not answerable to the creditors. This is not the case in equity financing.
Tax benefits are a big incentive for debt financing. Unlike private loans, interest fees and charges on a business loan are tax-deductible.
Options of the low-interest rate
Various loan schemes with low-interest rates are available to small businesses.
No sharing of profit
The creditors do not get a share in your profit. You are only bound to pay the agreed interest to your creditor within the agreed time frame.
Easy financial planning
You know well in advance how much principal and interest you will pay back each month. This helps in future financial planning
Disadvantages of debt financing
Difficulty in securing the loan
Banks are cautious when it comes to lending money. For new businesses, debt finance may be difficult to come by.
You must assure that your business can generate sufficient revenue to pay off the debt and the interest incurred at regular time intervals. Even if the company fails to generate profit it is obligated to pay its debt.
Inadequate cash flow
Making timely payments has the potential to affect your cash flow. In start-up enterprises, cash flow issues are prevalent, making regular payments difficult.
Any business that employs debt financing is at risk of going bankrupt unless it has a solid plan in place to repay the loan. This is especially dangerous if you have pledged your assets as collateral for a loan.
Impacts credit rating
Every loan you take for a business will reflect on your credit rating.
What is known as equity financing?
The sale of company shares to raise capital is referred to as equity financing. It can refer to the selling of any type of equity instrument, including common stock, preferred stock, share warrants, and so on. When investors buy shares in a company, they are also buying ownership rights in the company.
To finance plant assets and initial operational expenses, equity financing becomes an important tool, particularly during a company’s inception stage. Investors profit from dividends or when the value of their stock rises.
What are a few major sources of equity financing?
Angel investors, crowdfunding platforms, venture capital firms, or corporate investors could be a few major sources for private companies to raise capital. Ultimately, shares can also be sold to the public in the form of an IPO.
Advantages of equity financing
Alternate source of finance
It is not always possible for emerging start-ups to qualify for large bank loans. In such a case the main advantage of equity financing is that it offers such companies an alternative funding source to debt.
Typically, investors focus on the long term and do not expect a quick return on their investment. Instead of focusing on debt repayment and interest, it allows the company to reinvest cash flow from its operations to grow the business.
Helps maintain cash flow
In the event of equity financing, the corporation is only required to pay dividends on profits to shareholders, as opposed to paying interest at regular intervals in case of a loan. This aids in the company’s cash flow management.
From the company’s end, the risk involved is less. As you don’t have to pay a fixed payment as in case of a debt.
Access to better management expertise
Equity financing also provides certain advantages to the management of the company. Some investors are personally motivated to contribute to a company’s growth and want to be involved in its operations. Their successful experiences enable them to offer essential support in the form of business contacts, management skills, and access to additional financing sources. Many angel investors and venture capitalists are willing to help businesses in this way. It is crucial during the early stages of a company’s development.
Disadvantages of equity financing
Dilution of ownership and operational control
The major disadvantage of equity financing is that it requires business owners to give up a portion of their ownership and control. If the business becomes profitable and successful in the future, a portion of the profits must be distributed to shareholders in the form of dividends.
Many venture capitalists demand up to 50 per cent equity share, especially from firms with little financial experience. Many business owners and founders are hesitant to give up such significant control of their company, which limits their equity funding alternatives.
Cost and lack of tax shields
In comparison to debt, equity investments provide no tax benefits. Dividends paid to shareholders are not tax-deductible expenses, although interest payments are. This results in a rise in the cost of equity borrowing.
In the long run, equity financing is believed to be more expensive than debt financing as investors demand a higher rate of return than lenders. When funding a business, investors take on a lot of risks, so they demand a bigger return.
Not all investors may agree on a certain decision. They may have varying personal goals for the company’s development. These are challenges that the company’s founders will have to cope with.
Debt vs equity
Let’s assume your company named ‘Olive’ intends to scale up its business by purchasing new equipment, land and factories. It estimates that it needs to raise Rs. 100 crores in capital to fund its expansion.
To execute this, the Company decides to adopt a combination of equity financing and debt financing. The debt financing component obtains a business loan from a bank for an amount of Rs. 65 crores, with an interest rate of 3.5% per annum. The loan is to be repaid over five years. For the equity financing component, the Company sells a 10 % equity stake in its business to a group of investors and in return receives Rs. 45 crores.
With the given scenario, there could be a variety of possible combinations that result in different outcomes. If for example, Company Olive decided to raise capital solely through equity financing, the owners would have to give up more ownership, reducing their share of future profits and decision-making power.
In contrast, if they were to rely solely on debt financing, their monthly expenses would be higher, leaving less cash on hand for other purposes and a larger debt load to repay with interest. Businesses must choose the best option or mix of options for them.
When we look at the benefits and drawbacks of debt and equity financing, it is evident that the phrase “Equity Capital reflects ownership, while Debt Capital reflects an obligation” generally holds good. However, the phrase cannot be viewed in its entirety. Other factors must be considered when determining if a given type of financing will result in retention of ownership or will become a liability.
A corporation may choose debt financing, produce reasonable profits, and return the debt without losing ownership or incurring any obligation. Similarly, a company’s promoters may dilute their shares to raise funds and lose a portion of their ownership.
Which is better for your business: debt or equity financing, and why? The short answer is that it is debatable. The decision to go with equity or debt is based on several criteria, including the present economic climate, the company’s existing capital structure, and the company’s life cycle stage, to mention a few. The best form of financing can be a combination of the two or the company may resort to any one of the methods depending on the existing factors. The phrase “Equity Capital reflects ownership while Debt Capital reflects an obligation” may generally hold good but it is clear that a company can employ either type of financing and fulfil its need for capital expansion without losing ownership or incurring liabilities through proper planning and management.
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