Finance

Difference Between debt Financing and Equity Financing

Difference Between debt Financing and Equity Financing

Whenever the company is considering expanding its business, an investment or funding is necessary for the company to meet the expenditures of its business operations. While there are multiple funding options available to a company, one of the major decisions for a company to make is on debt financing and equity financing. The company shall ensure the difference between debt financing and equity financing. After a systematic, thorough evaluation, the company must decide on a funding financial solution, either with equity financing or debt financing.

It is indeed common among companies to assess the difference between debt and equity financing, understanding this difference is vital for a company to have informed decisions on the fundraising procedures from the respective investors. This understanding of the difference between debt financing and equity financing will help the company to come out with the best possible options for meeting the business expenditures for growing the businesses.

With the ever-changing business dynamics in recent years, various forms of financial funding channels have emerged, with multiple financial products ensuring companies with diverse financial funding options. However, despite the diversity of financial funding options, both debt financing and equity financing are the major and common types of financial solutions for organisations. Though both equity financing and debt financing meet the company’s business expenditures, there is a significant difference between debt financing and equity financing.

Exploring the Contrast: Debt and Equity Financing

The main difference between debt and equity financing is that debt financing is those funds whore the borrower company has to repay the principal amount along with the interest payment on debt to an investor within a stipulated time. On the other hand, equity financing is a fund issued by the investors to a company in return for the ownership of the company shares without any repayment obligations. Organizations that raise capital to meet their business expenditures and needs commonly adopt two types of financial solutions, either equity financing or debt financing or both equity and debt financing, together to optimize their business growth. Companies often choose a combination of equity financing and debt financing, but there is a difference between debt financing and equity financing. Both equity financing and debt financing have a distinct advantage. The major principal advantage of equity financing is that it carries no repayment conditions on the company to the investors, thus providing extra working capital to meet the business expenditures, uplifting the business growth. On the other hand, debt financing’s principal advantage is that companies don’t have to transfer a portion of their shares to investors for financial funding.

Depending on the company’s business structure and cash flow, the company shall choose between equity financing and debt financing. Usually, the choice of a company for a financial solution depends on the cash flow, the availability of the source of funding, and the importance of maintaining control of the company for its principal owners. Moreover, the debt-to-equity ratio addresses how much of a company’s financing is proportionately fulfilled through debt and equity financing.

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What is Equity Financing?

Equity, in general, means a company’s net worth and source of permanent capital. The equity financing method, on the other hand, is a financial funding option that a company considers by selling shares of a company’s business to respective investors to meet the expenditures of the business operations to expand and development of the company. With the equity financing option, organizations are not liable to make a repayment of the money borrowed from the investors, unlike debt financing, but it means the company is transferring a share of ownership with the equity financing investors. Such transfer of ownership in the company’s share will hamper the company while making decisions and various other business controls, impacting the profit percentage that a company was solely entitled to.

What are the Characteristics of equity?

Here are the important characteristics of equity:

1.  The investors under the equity financing expectations are to receive a high return of capital amount from the company, but the scenario is unpredictable.

2.  There is no certainty about the future capital return. However, the required return is very high, and the risks involved are also very high depending on the organization’s ability to generate profits and greater value.

3.  The investors are involved in the company’s decision-making and management creating a division in the ownership of a company by taking away the organization’s complete ownership.

4.  Investors or shareholders have an opportunity to obtain wealth through the company’s dividend earnings as well as capital appreciation.

What are the Types of Equity Financing?

Here, given below are common types of equity financing:

Angel Investors

Angel investors are wealthy individuals who provide various funding and investments to companies to run their business operations. Such investors, in return, acquire shares or equity in the company’s business share or a convertible debt in exchange for an investment.

Venture Capitalists

Venture capitalists are organizations or individuals that provide investment funds to businesses, mostly to high-risk startups. In the long term, venture capitalists tend to obtain the company or, if traded publicly, a significant portion of the company’s shares.

Capital Raising Equity Crowdfunding

Capital raising crowdfunding is a procedure where a company sells a small number of the company’s shares to investors who have invested through crowdfunding platforms.

What is Debt financing?

Commonly, debt refers to a situation in which one person borrows money from another. It can either be an individual or a company. The debt financing of a business fund is similar to the company’s business operations. Here, the company raises funds from an investor with a promise to repay the principal amount with interest within a stipulated time. Unlike equity financing, no shares are transferred by the company to an investor for borrowing a fund for running a company’s business operations. Some of the common examples of debt financing in the business world are term loans, advance cash loans, invoice finance, and various other asset finance.

What are the characteristics of Debt Financing?

Given below are some of the main features of debt financing:

1.  The investors tend to obtain money lent to a company for meeting the business expenditures with both principal amount and interest.

2.  The returns are short-term, and the payment schedule must be known in advance.

3.  The lender does obtain a share in the company and has no role in the company’s management or decision-making.

4.  The lenders, before lending a debt financing to a company, examine the ability of a company to generate cash flow and efficiency to repay the debt loan amount within a stipulated time frame.

5.  Debt financing increases the liabilities of a company, worsening its credit scores if no other variable changes.

6.  Such Indebtedness reduces the capital of a company and drains out the generation of a company’s free cash that is utilized to serve the contracted debt. 

What are the Types of Debt Financing?

Given below are the types of debt financing:

Standard bank loans

Standard bank loans are loans that are affordable yet challenging compared to other alternative lenders.

SBA loans

SBA, or a Small Business loan, is quite popular among entrepreneurs. It offers loans to businesses with low-interest rates for a longer term, but its approval is difficult to obtain.

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Merchant Cash Advances

A merchant cash advance is a kind of cash advance is a type of financial lending based on the company’s business future revenue. On the other hand, merchant cash advances annual rates of percentage are extensively high.

Lines of Credit

Lines of credit are those funds that are drawn by the company only when they are needed and pay interest only on the amount that is used by the organizations to meet the company’s

Business Credit cards

Just like personal credit cards, business credit cards are also used by the company to meet business expenses with other benefits like spending rewards which are not available with the business credit lines.

What is the difference between debt financing and equity financing?

The major key differences between debt financing and equity financing are as follows:

Ownership

In debt financing, there is no transfer of the company’s share ownership to an investor to lend funds to meet the company’s business expenditures. In equity financing, investors, in return, become a part of the company’s shareholders, obtaining voting rights that may impact the decisions of the company. However, equity financial investors may provide essential support to a company in terms of both financial and non-financial resources and various other company decisions.

Risks

In debt financing, the company has to keep collateral for obtaining a loan, such as an estate or equipment, so that whenever the company is unable to repay the loan amount, such collateral will be automatically seized by the financing company to recover the debt amount.

Whereas, equity financing risks are lower than the point of view of an investor since obtaining ownership in the company’s share provides future capital appreciations and dividends which could be endless.

Repayment

When it comes to repayment in debt financing, the borrower company has to make a monthly repayment in instalments along with the principal amount and interest within a stipulated time frame. In equity financing, a company is not required to make a repayment on the amount landed by the investor; instead, an equity share is given to the investors.

Funding Procedure

Debt financing is an easy process to obtain funding from investors as it takes less time than equity financing. It may take weeks or even less than a week. On the other hand, the equity financing procedure is lengthy and not the best option for quick financial solutions.

Involvements

In debt financing, there is no such involvement of the lender in the company’s decision-making since, in debt financing, a company only borrows funds with the promise of repaying within a stipulated time, attaching collateral properties in return. Unlike debt financing, equity investors become shareholders of the company, playing a key role in the company’s decision-making and various other profits and losses from the business operations.

Pros and cons of Debt financing and equity financing

Every type of financial solution has various advantages and disadvantages. The pros and cons of both debt financing and equity financing are given below.

Debt Financing Pros & Cons

1.  Obtaining debt financing is easier and faster for meeting the urgent capital requirement of a company for business operations or other expenditures.

2.  Debt financing does not dilute the company’s ownership, and thus, investors play no role in the decision-making and management of a company.

3.  Obtaining a debt loan by a company increases the credit score, easing the credibility of a company for future debt financing.

4.  Companies in debt financing have to repay the loan amount with interest and principal amount within a stipulated time frame, which can be expensive.

5. If the company is not able to pay back the debt loan, there is a high chance of the company going bankrupt.

6.  It also limits the financial capabilities of the company due to the obligations to make a regular installment of the debt amount to the investors.

Equity Financing Pros & Cons

1.  In equity financing, there are no obligations for a company to repay the loan amount. Such conditions relieve the struggling and startup businesses.

2.  The company gains significant funding through equity financing.

3.  Through equity financing, companies attract experienced investors, providing guidance and advice for operating the company’s businesses.

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4.  It dilutes the company’s ownership, sharing the business control with the investors.

5.  The decision-making of the company is hampered by the obtaining of equity financing.

6.  Companies may receive extensive pressure from investors since investors tend to receive back their return amount.

Conclusion

Both debt financing and equity financing are two major procedures for a company to secure capital for a business operation, each with its advantages and disadvantages. In general, debt financing is less expensive than equity financing but comes with higher risk than an equity financing solution. Debt financing is a method that involves a company borrowing money from the lender investor, creating a relationship between the creditor and the debtor. It allows the company to obtain the funds quickly, unlike equity financing, while maintaining its ownership in the company’s management. However, the company under the debt-equity has to make a repayment on a monthly instalment or yearly basis regardless of the company’s profit or loss. Organizations’ failure to repay such debt fund amount to a lender has to face penalties and even lead to bankruptcy.

Equity financing on the other hand involves selling shares by the company to a respective lender allowing lenders to be part of the company’s decision-making. Though there is no need to make regular repayments on the amount taken from the investors unlike debt financing however both lender and company become shareholders sharing both risks and rewards obtained from the company’s business operations.

Lastly, the best financial solutions for any company depend on the various factors and circumstances of the business’s financial structures and operations for example a company in the early phase of growth often chooses equity financing over debt financing, while the companies already established obtained both equity financing and debt financing for optimizing their business growth and goals.

FAQ’s

  1. What is Debt financing?

    Debt financing is a loan issued by the investors or lenders to a company to meet the company's business operations expenditures and in return company has to repay the money as debt within a stipulated time via debt agreements. It also creates a creditor and debtor relationship with an obligation to make regular payments including both principal and interest.

  2. What is equity financing?

    Equity financing is a financial solution where a company sells its portion of the share to investors in return for the capital or investment to meet the business expenditures. Potential to return in the form of dividends and capital appreciation to a lender or investors.

  3. Which method is cheaper, debt financing or equity financing?

    Debt financing is considered way cheaper than equity financing because the interest payment on debt financing is tax-deductible, ensuring tax efficiency. At the same time, equity finance involves the sharing of shares and profits with the investors and impacts decision-making.

  4.   Which method is more suitable for startups or small businesses?

    For every startup and small business, equity financing is the best financial solution since they have limited assets and a track record of securing the debt amount. Equity financing allows startups to attract investors who tend to believe in the idea and potential of the business growth in the future. Thus, investor funds equity to companies in exchange for the ownership stacks in the business.

  5. Can a company use both debt and equity financing?

    Yes, the company can use both debt and equity financing to meet its business expenditures or to optimize the company’s business structure. The combination of both debt and equity financing helps the company gain benefits from the advantages of both methods while managing risks and costs effectively.

  6. When should I choose equity financing?

    Companies should choose equity financing when they want to share the business risk and profits with the investors. Most commonly, organizations obtain equity financing when they are not comfortable in debt-related obligations building creditor and debtor relationships. It is the best choice for startups and high-growth companies.

  7. When should I choose debt financing?

    One should choose debt financing when they have a potential cash flow from the business operation and are comfortable in meeting interest and principal repayments for capital borrowed from the investors. Whenever the company wants to obtain a complete ownership debt financing is the best choice for meeting the business expenditures.

  8. How is the company's balance sheet affected by the company's choice between equity and debt financing?

    Equity financing by a company increases the section of equity in the company's balance sheet, whereas debt financing increases the company's balance sheet section of liabilities. However, such a financial solution impacts the financial leverage of a company and thus attracts more number investors.

  9. How do both equity and debt financing affect the risk profile of the company?

    In Equity financing company tends to share the risk between the investors and the company’s owner, whereas in debt financing the company's risk increases with the obligation to repay the loan amount including both principal and interest especially when the company is facing a financial downturn.

  10. What is an example of a debt financing type?

    Some of the major examples of debt financing are bank loans, lines of credit, credit cards, equipment loans, etc.

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