Corporations regularly need infusions of money – perhaps to hire new employees, fund new projects or raise money for an acquisition. In this situations, they typically face a choice between two options: debt financing and equity financing. Debt financing is another term for borrowing. Equity financing involves selling part ownership of a company in exchange for money. Here’s how each financing method works, and the pros and cons of each.
With debt financing, a business receives money that it is obligated to pay back. Usually, the repayment occurs with a series of monthly or other regular payments. In addition to paying back the borrowed amount, the business has to pay interest to compensate the lender.
The borrower often has to put up collateral that the lender may claim ownership of if the borrower doesn’t make the payments as required. However, beyond this the lender doesn’t get any ownership of the business. This is a crucial difference between debt and equity financing.
There are numerous types of loans. Selling bonds is another form of debt financing, and one of the most common for corporations. Both public and private corporations issue corporate bonds, which are a type of fixed income security. Corporations place these investments on the open market to help fund projects and other major financial undertakings. Investors can purchase corporate bonds on either the primary or secondary markets, and they offer predictable payouts and strong liquidity.
Corporate bonds are structured in a wide variety of ways: fixed interest rate, variable interest rate, zero coupon, convertible, callable and junk.
Bank loans are another common way corporations obtain money through debt. Just as consumers get bank loans to buy cars, business owners get bank loans to buy equipment, build warehouses and add employees. Alt-fin and fintech lenders take applications online and use algorithms to qualify borrowers with no need to enter or use a bank to get a loan.
In addition to bank loans for specific amounts and purposes, there are lines of credit. These may be used for any purpose or left unused until needed. Accounts receivable or invoice factoring is a kind of debt financing that lets businesses borrow using bills to customers as collateral. Business credit cards are also a type of debt financing.
Debt financing is easy to obtain. A business owner fills out an application and perhaps meets with the lender to explain how the loan will be used and repaid. It takes little time and the main requirements are financial stability and sufficient cash flow to make payments.
With equity financing, business owners are selling part ownership of the business in exchange for money to expand or improve it. There are no regularly scheduled loan payments or interest to pay. But business owners will surrender a level of control and decision-making authority approximately equal to the ownership share they are selling.
Equity financing also comes in several types. Selling shares to the public on the stock market is a common form of equity financing. So is selling part ownership to venture capitalists in exchange for money to fund a startup. These are long-established ways to raise business capital. Crowdfunding is a 21st century innovation that uses the internet to raise capital from many small investors. It sometimes offers equity in exchange for capital.
Pros and Cons of Debt and Equity Financing
The pros of debt financing include no loss of control, less delay in receiving funds and many options for obtaining it. You can also get tax benefits by claiming interest on debt as a deduction from profits. Debt financing is often the only choice for most companies because they lack the growth prospects equity investors want.
Cons of debt financing include the fact that it locks the company into what may be a long series of sizable payments. It can be hard to qualify for loans at attractive rates – or any loans — especially for companies most in need of capital. If the business can’t pay the loan back, it risks default and even being forced into bankruptcy.
Pros of equity financing include little or no requirement to use scarce cash to repay the supplier of money. Equity investors are essentially taking on part of the same risk the owner does. They are betting that the business will succeed, and their stake will be worth more someday. This can make equity financing a good fit for many startups, which lack the track record and financial strength to qualify for loans but have good long-term growth prospects.
Cons of equity financing include loss of control. Equity investors will require a share of the profits as well. It also takes much longer to obtain equity financing than it does to get a loan.
These two sources of financing have significantly different traits and impacts on a business. Which one is best suited depends in part on the business’s age, size, stability, profitability and prospects for growth. The business owner’s personal inclinations toward taking on risk and sharing control are also critical.
- Consider talking to a financial advisor about debt and equity financing. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- While some business owners are hesitant to take on debt, it’s important to tell the difference between “good” debt and “bad” debt. Here’s a useful primer on how to tell the difference.
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