Question

This is a classic corporate strategy decision. Do we raise additional capital to finance operations and/or growth by issuing bonds (debt) or by issuing stock (equity)? In your own words, what would factor into this decision? Name some pro's and con's of each alternative.

Answer 1

• Debt and equity financing are two very different ways of financing business.
• Debt involves borrowing money directly, whereas equity means selling a stake of the company in the hopes of securing financial backing.
• Both have pros and cons.
• Here's an introduction to both debt and equity financing, what they mean, and important things to know before making your decision.
• debt financing:

• The borrower accepts funds from an outside source and promises to repay the principal plus interest, which represents the "cost" of the money you initially borrowed.

  Borrowers will then make monthly payments toward both interest and principal, and put up some assets for collateral as reassurance to the lender. Collateral can include inventory, real estate, accounts receivable, insurance policies or equipment, which will be used as repayment in the event the borrower defaults on the loan.

Debt financing includes traditional loans from banks

Types Of Debt Financing

There are multiple types of debt financing, The type of financing select will depend on your specific circumstances. Let’s take a look at a few of the most common types of debt financing.

Loans

Loans are what most people think of when discussing debt financing. A loan is a lump sum of money given to you that is repaid over a set period of time. A long-term loan is paid back over several years; this is the type of traditional funding you would receive from your bank or through a Small Business Administration program. These loans are best for larger business purchases, such as equipment or commercial real estate and are typically only available to those with good credit and established businesses.

Short-term loans offer quick cash to borrowers with less ideal credit and time in business qualifications and (as the name would suggest) are repaid over a shorter period of time. These products are best for smaller purchases, such as supplies and inventory, or to cover an emergency expense.

Lines Of Credit

Lines of credit offer a more flexible financing option. With a revolving line of credit, you’ll be able to make multiple draws against a credit limit set by your lender. As you repay your principal, interest, and fees, funds will become available to use again. You can withdraw up to and including the credit limit through one or multiple draws. Once you initiate a draw on your line of credit, the funds are sent to your bank account, where you can access them in as little as one business day. Lines of credit are particularly useful for emergency expenses or working capital.

Business Credit Cards

A business credit card works just like a personal credit card. Your lender sets a credit limit, and you can make purchases with the swipe of a card anywhere credit cards are accepted. You’ll repay any funds used, in addition to any interest charged by the lender. Interest is applied only to the borrowed portion of funds. Business credit cards can be used to purchase supplies or inventory, pay for unexpected expenses, or to set up recurring payments (utility bills, etc.).

Accounts Receivables Financing & Invoice Factoring

Accounts receivables financing — or invoice financing — uses your unpaid accounts receivables as collateral for a line of credit. Invoice factoring is also an option. This is when you receive a lump sum of money up front for your unpaid invoices. Once the invoices are paid, you receive the remaining amount owed to you, minus any fees charged by the lender. Both are good options to improve cash flow that has slowed due to unpaid invoices.

Debt Financing Pros & Cons

Debt financing certainly has its benefits, but there are drawbacks you must consider as well. Let’s take a closer look at the pros and cons of this type of financing:

Pros

• Retain Business Ownership: With debt financing, ownership interest is not diluted.
• Multiple Options Available: From flexible lines of credit to long-term loans that give you a lump sum of cash, you can find debt financing for any situation.
• Planning Ahead: With debt refinancing, you know exactly when to pay, how long you’ll be paying, and the amount of each payment.
• Tax Benefits: Interest for your financing can be used as a deduction on your income tax return.
• Availability: Debt financing options are available to almost all businesses, regardless of factors such as size, industry, time in business, or business or personal credit history.

Cons

• Interest & Fees: Even borrowers with the highest credit scores and most profitable business have to pay interest and/or fees for borrowing. Borrowers that are seen as “risky” by lenders face even higher costs.
• Taking On Debt: True to its name, debt financing means you are taking on debt. This raises your DTI ratio, making business look like a bigger risk to investors and lenders.
• Risk Of Default: Even the well-intentioned borrower can fall upon hard times and miss a payment. Months of hardships can lead to default, which puts your collateral and credit score at risk.
• Difficult Borrowing Requirements: Even though there are many debt financing options, we may not qualify for the product you need.
• Potential Restrictions: Some lenders impose restrictions on how funds are used. If you want more flexibility than what one lender is offering.

Equity Financing

Equity finance is a method of raising fresh capital by selling shares of the company to public, institutional investors, or financial institutions. The people who buy shares are referred to as shareholders of the company because they have received ownership interest in the company.

Types Of Equity Financing

Venture Capitalists

Venture capitalists (VCs) are willing to invest millions of dollars in companies that have the potential for high returns. Therefore, most small businesses would not be of interest to VCs. However, promising tech and innovation startups could benefit from the equity financing offered by VCs. VCs use money that is pooled from sources, including investment companies, corporations, or pensions. It is rare for a VC to use their own money for investment.

Angel Investors

Angel investors, like VCs, are willing to invest money in promising businesses and startups. However, angel investors are a little different because these are accredited investors who use their own money for investments. An angel investor may be someone we don’t know, or it could even be a friend, family member, or colleague who has a high net worth and annual income.

Crowdfunding

The internet has made it easier than ever for small businesses to raise capital. With crowdfunding, you can make your pitch to the public to raise capital for your business through an online platform. While some businesses promise rewards in exchange for investments, such as a new product for free or at a reduced price, others use equity to bring in investors. Learn more about the best equity crowdfunding sites.

Initial Public Offering

Shortly known as IPO, it occurs when a business decides to “go public." Going public is the process when you make your company's shares available to all. Before the IPO, your shares are available only to specific groups of people, with whom you distribute it. After an IPO, the shares of your company are publicly traded on markets

Equity Financing Pros & Cons

Similar to debt financing, equity financing has benefits and drawbacks to consider.

Pros

• Investors Take On Risk: With equity financing, the risk falls primarily on the investor. Investors only see their returns if your business is a success.
• Good For New Businesses: If you’re a brand new business with no revenue, equity financing could be the best option for you. While you may qualify for debt financing, you’ll likely be stuck with low borrowing limits and less-than-desirable rates and terms.
• No Interest Or Fees: With equity financing, you won’t have to worry about paying interest and/or fees on a loan or other financial product. This gives you more money to invest in your business.
• Investors Bring More To The Table: The right investor brings more than just capital to the table. You can gain industry knowledge, meet new connections, and gain experience that you wouldn’t receive by working with a lender.
• Less risk: You have less risk with equity financing because you don't have any fixed monthly loan payments to make. This can be particularly helpful with startup businesses that may not have positive cash flows during the early months.
• Credit problems: If you have credit problems, equity financing may be the only choice for funds to finance growth. Even if debt financing is offered, the interest rate may be too high and the payments too steep to be acceptable.
• Cash flow: Equity financing does not take funds out of the business. Debt loan repayments take funds out of the company's cash flow, reducing the money needed to finance growth.
• Long-term planning: Equity investors do not expect to receive an immediate return on their investment. They have a long-term view and also face the possibility of losing their money if the business fails.

Cons

• Giving Away Ownership: With this type of financing, you’re giving away ownership in your business. Not only does this reduce your share of profits, but it also gives outside parties the power to make decisions surrounding the operations of your business.
• Finding Investors Is Difficult: Finding one or more people willing to invest in your business can be a difficult and time-consuming process. If you need money quickly or with little effort, equity financing is likely not the right option for you.
• Cost: Equity investors expect to receive a return on their money. The business owner must be willing to share some of the company's profit with his equity partners. The amount of money paid to the partners could be higher than the interest rates on debt financing.
• Loss of Control: The owner has to give up some control of his company when he takes on additional investors. Equity partners want to have a voice in making the decisions of the business, especially the big decisions.
• Potential for Conflict: All the partners will not always agree when making decisions. These conflicts can erupt from different visions for the company and disagreements on management styles. An owner must be willing to deal with these differences of opinions.