Pros and cons of debt vs equity finance

When seeking additional funding for your company, you will likely be faced with two options - debt finance or equity finance. Both come with their pros and cons, as the first will result in you having to repay a loan over a set period and the second having to give away shares in your company. The need to bring in outside money is not necessarily a negative reflection of a company's financial state. It could be that you have found an investor who has the contacts, talent and available equity to fuel your company's growth. There are also some excellent business loan deals that may align with your financial business plan. Whatever your justification for funding, carefully weigh up the options and select one that best fits your business goals.

INTRODUCTION

In every entrepreneur's life, there comes a time they will want to launch a new business and fuel its growth. But, for most, they will need to bring in outside money to fund and fuel their business venture – even if it is only to multiply what is working or create a source of emergency capital.

Traditionally for family-run businesses, the favoured way is to keep everything in-house and self-finance. This is essentially using their own money to start and grow the business. But unfortunately, although there is the benefit of retaining all control and keeping profits within the family – it is seldom a sustainable solution for ambitious long-term growth.

The majority of business owners will need to explore outside money options. The two primary business funding opportunities are debt financing and equity financing. These two primary options involve leveraging debt finance (resulting in having to pay back a loan) or releasing shares for equity investors (resulting in loss of company control).

Deciding which financing route is the best decision for your company can be challenging. Each option has its pros and cons, which you need to examine as part of the company's bigger growth landscape, deciding which option is best at any particular time. This article provides you with the basic information needed to consider which option you may want to consider for financing your business.

WHAT IS DEBT FINANCE?

Funding will inevitably involve some form of borrowing. For example, businesses can take on an amount of debt mainly in the form of a business loan or line of credit with the agreement of paying it back over a set time frame. Debt finance is usually arranged via a bank, crowdfunding or another form of lender – usually with an interest rate and fixed term attached.

There can be a lot of admin and red tape to get through before being able to secure debt finance. Due to the regulatory burdens and complex information requests, you will need to prove the company's current cash flow position. This means providing copies of bank statements and any documents that prove your creditworthiness. In addition, the amount you are seeking to borrow and your trading history will be key influencers in determining the funding approval.

Luckily for many businesses, the process for debt finance has been simplified over recent years. Many providers now make their applications available online, and processing can be completed within days. Although the process has become paperless and streamlined, core information is still needed.

THE PROS OF DEBT FINANCE

• When taking the debt financing route, you will retain full ownership and control of your business. This means the profits are all yours, and the lender has no claim on any company equity.
• One of the main positives of being on a fixed-term loan is the light at the end of the debt tunnel – the end date for repayments. Once you have cleared your debt by paying the total amount borrowed (plus interest), you and the company will have no further commitment to the lender.
• Business loans will come with some terms and conditions, but you are generally free to spend the money as you think best. If you have any concerns about spending or investing the money, the company could seek financial planning advice.
• It is possible to reduce the overall cost of the finance to your company by deducting interest on the debt from the business taxes.
• For companies with strong cash flow management and an excellent credit rating, it can be easy to get an approved loan or credit line.

THE CONS OF DEBT FINANCE

• When you agree to take debt finance, the company is committed to repaying an agreed sum of money over a fixed period. If you run into any cash flow issues during this time, it can have an adverse effect as repayments are required by law.
• The majority of lenders will require you to have a personal guarantor for a business loan. This means that if you are listed as the guarantor, you will personally be held responsible for any missed or late repayments.
• Your company may find that the interest on the loan is a constant drain on your bottom line. As a result, there is the possibility no revenue is left to reinvest into your business.
• You will need to manage the level of debt your company takes on closely. If you end up taking on too much debt, your company could be viewed as too high-risk by future investors.
• There is no guarantee that a lender will agree on the level of finance applied for. Once they have made a decision, there is very little wiggle room – it is always a good idea to have a backup plan for any shortfall.
• Some lenders may require additional security if you are applying for a large loan. For example, they may request a charge over your assets if you put in for a property loan.

WHAT IS EQUITY FINANCE?

Equity finance involves giving away part of your business in return for incoming capital. The main objective is to retain the majority of shares to have an overall charge. However, you are likely to be answerable to shareholders who have invested in your company.

Businesses often use this funding option during a pre-revenue or fast growth phase or by those wanting to acquire another company but have limited access to finances. Unlike debt finance, there is no fixed amount to be repaid – instead, an equity investor gains part of the ownership in the company. In addition, this results in the investor having a share of any paid out dividend and profit generated if the company is sold or bought out. The investor also receives associated voting rights which are laid out in a shareholder agreement.

When it comes to equity finance, the business and its investors need to build a close relationship. This can be through friends, family or funding from angel investors, venture capital firms or crowdfunding platforms.

THE PROS OF EQUITY FINANCE

• For those who find debt uncomfortable, equity finance can offer a solution for their funding needs. The investors get a return from dividends paid out from profits or the sale of the business.
• The investor carries the risk of financing your business as there is no obligation for you to replay them if the business fails. However, you must show the investor that the potential reward is worth taking the risk to finance your company.
• There are some very experienced investors out there who may be able to bring more than just money to your business. These individuals can provide the expertise, knowledge and contacts to help you grow your business. After all, the better your company does, the more likely they will see a positive return on their investment.
• Looking after a business's day-to-day running is stressful and demanding work. There is the possibility of alleviating some of the burdens by splitting the responsibility of strategic decision-making between you and equity shareholders.

THE CONS OF EQUITY FINANCE

• Through equity finance, you will lose a share of your business. As a result, the value of your current or projected dividends will be reduced – as you will be sharing it with the equity shareholders.
• With extra people having a say in running the business, you will lose some control. The extent of the loss with regards to decision-making will be outlined in detail in a shareholder agreement.
• Unlike filling out an online debt finance application, finding the right investors can be hugely time-consuming. Relinquishing control of your company will require a lot of trust that the potential shareholder agrees with your business goals and vision.
• There is a lot of groundwork involved in pitching to investors. First, you will be required to create a pitch deck, business plan and provide supporting financials. Investors will also want to complete due diligence and for you to prove the long-term sustainability of your business. There is then the critical task of negotiating the terms of the shareholder agreements.
• In the majority of cases, the only way to regain full control of your company again is to buy out your investors. This may involve having to pay them more than what they initially invested.

FINAL THOUGHTS

There is a use for both debt and equity financing when launching or growing a business. The decision will be based on which suits your needs at the particular time. For example, debt financing may work at one point in your company's journey, and equity financing is a better option at another time. In addition, equity can bring some external resources to your business, so it is excellent if you would like to benefit from more than just a capital injection. On the other hand, if you want to get a fixed-term loan with regular payments, debt financing is better. Debt financing also allows you to retain complete control of your business and any profits it generates.

FREQUENTLY ASKED QUESTIONS (FAQS)

Why do companies prefer debt to equity? It comes down to one thing – maintaining ownership. Business owners prefer to have control over their company. Unlike equity financing, debt financing allows your business to retain equity which means you continue to have complete control. There is also the added advantage of business loans being tax-deductible.

Is debt financing a cheaper option than equity financing? Debt tends to be considered a cheaper source of financing as the interest is less expensive, has lower issuance costs and has tax benefits. On the other hand, equity financing is more costly as there is a greater risk to shareholders than lenders – debt payments are mandatory by law, regardless of a company's financial position.

When do companies use equity financing? Equity financing is most popular with start-ups that need short-term cash. It is common practice for start-up companies to apply equity financing several times during their journey to reaching maturity. The two equity financing methods include private placement of stock with investors and public stock offerings. Is debt financing or equity financing riskier? Equity financing is riskier than debt financing when it comes to the investor's best interests. This is because a company typically has no legal obligation to pay dividends to common shareholders. There is also the matter that much of the return on equity will be tied up in stock appreciation, which is required to grow revenue, profit and cash flow. A typical investor will want at least a 10% return due to risks, while debt financing can generally be found at a lower rate.

How does a business decide between debt and equity financing? Debt financing involves borrowing money to be repaid (plus interest), while equity financing requires a business owner to sell interests in the company to raise money. So essentially, you will need to weigh up whether you would prefer to pay back a loan or give shareholders stock in your company.