Understanding Core Concepts

Understanding Equity vs Debt Financing

If you’re looking to break into finance or even potentially own your own company someday, differentiating and understanding equity vs debt financing is a foundational concept within this competitive sphere. Being able to describe when a company should either raise equity or debt is a topic that arises among most interviews and overall is a concept that should be understood. It it key to understand the differences between the two as well as why people choose one over the other when seeking to raise capital.

Let’s take a look…

Equity Financing

Equity financing involves a company selling a portion of their equity in order to raise capital. This would allow the company to receive capital they may need to either grow or finance operations, however they are giving up ownership of their own company.

Sources of Funds

1. Venture Capital (VC) firms

2. Angel investors

3. Initial public offering (IPO)

4. Crowdfunding

5. Corporate investors

Advantages vs Disadvantages of Equity Financing

Advantages

• No obligation to repay the money acquired

• No financial burden

• No interest rate risk

Disadvantages

• The company is forced to give up partial ownership (you will have to share profits with investors and the only way to retain equity is to buy them out)

Debt Financing

Debt financing involves borrowing money and then repaying the principal back plus interest. It is important to note that once companies receive money through debt financing, they are typically restricted to using that money within their sphere or operations in order to mitigate risk. Creditors want to be able to receive that money down the road plus interest, therefore they don’t want companies to use their money in speculative investments. Additionally, creditors seek to lend money out to companies with a low debt-to-equity ratio, as risk is lower, therefore there is a higher chance that they will lend money out again to a company with a healthy ratio.

Sources of Funds

1. Business lines of credit

2. Invoice factoring

3. Term loans

4. SBA loans (small business administration)

5. Personal loans

6. Peer-to-peer lending

7. Business credit cards

Advantages vs Disadvantages of Debt Financing

Advantages

• Companies don’t have to give up partial equity (lenders have no control over the business)

• Interest on loans are tax deductible

• Considered safe and predictable, as loan payments are typically fixed

Disadvantages

• If the company fails to grow with the money they received, they have incurred a major expense, which in turn hurts a companies ability to grow

• Lenders may require collateral in the form of a companies assets, putting a lot of pressure on the need to grow with the money you received from debt financing

Key Takeaways

• Firms will choose equity financing if they do not wish to take on debt

• Firms will choose debt financing if they do not wish to give up ownership

• Equity financing could cost more as you are giving up power over a company as well as a portion of its profits

• Companies usually do a mix of equity and debt financing, rather than choosing just one option

• Businesses with inconsistent cash flows may choose equity financing as obtaining a loan could be difficult

• Debt financing is typically faster, as the IPO process could take a lengthy amount of time