Are you a startup? Are you not able to decide between equity and debt sources of financing?. Then this article may be of great help to you.

I am going to cover the concept, the advantages, the disadvantages & the differences between equity & debt financing. Wherever applicable, I have included relevant formulas & examples.

Right funding is critical to the success of every business. Thus you need to plan properly so as to tap right sources of funds for funding your startup. Financing is the bedrock of every business growth, whether in the startup phase or in later stages of the business cycle.

Many businesses fail not just due to lack of funds but also due to inappropriate sources of financing.

The two traditional sources of startup financing are equity financing and debt financing.

What Is Equity Financing?

Equity financing refers to raising finance for the business in exchange for a stake in the share capital of the company.

The holder of a share in the share capital of the company is known as a shareholder. Shareholders are the real owners of the business. They have a claim on the future profits of the business. The profit or loss of the business is ultimately shared amongst them. They also have a say on the decisions of the company by virtue of their voting rights that comes hand in hand along with a share in the share capital of the company.

Equity shares issued for raising equity funds do not carry a fixed periodical financial commitment (unlike interest in case of debt). Rather the company to pay some portion of its annual profits as the dividend to the shareholders provided it has adequate profits (i.e. excess of incomes over expenditures).

What Is Debt Financing?

Debt financing, on the other hand, refers to raising funds for the business by the issue of debt securities, such as debentures, bonds, mortgage loans, and borrowings from banks and other financial institutions.

The lenders provide funds in return for an agreement to receive fixed financial returns in the form of interest at a specified rate and interval. The loan is provided for a fixed term as agreed between the company and the lender. At the maturity of the loan agreement, the company has to repay the principal amount to the lender.

The holders of debt securities do not acquire ownership in the company and hence no voting rights. Lenders are regarded as outsiders for the business as they just provide funds and are least bothered about the operations of the business. Interest on debt is a fixed financial charge on the company.

There is an obligation on the company to pay the interest on time irrespective of its profit earnings. Even if the business is running at loss, the company has to pay interest to the lenders. Failure to pay timely interest will result in accumulation of outstanding interest in the books of the company and loss of financial standing. This also invites fines, penalties and legal prosecutions.

Equity shares carry more risk as compared to debt securities because of some reasons (from investor point of view). Firstly, the lenders are guaranteed a fixed rate of interest for each period; whereas the shareholders get dividend only if profit remains after satisfying the claims of the lenders in full. Secondly, the dividend paid to the shareholders fluctuates from period to period but the lenders are assured of a constant income for each period. Thirdly, at the time of liquidation of the company, the lenders are repaid the principal money in preference to the shareholders.

In the starting phase of the business, equity financing is very much required because the company has just started its operations. There is no guarantee that it will earn profits in the first or second year. Taking loans will exert a pressure on the company to make early profits. For this, the business may deviate from long-term success paths for short-term gains.

Equity financing is the first step of raising funds and is a must. Because without owners’ investments the business cannot borrow additional funds form financial institutions. Sufficient owned funds instill confidence among the lenders as they think that the owners are taking the first risk and are interested in the venture’s success.

However, a company cannot rely only on owned funds. Additionally, it is also prudent to use some debt in its capital structure so as to leverage on equity. In order to understand this in detail, let’s first discuss the pros and cons of equity and debt financing.

Equity Financing:

Pros:-

1. No Fixed Financial Obligation

In equity financing, there is no fixed financial burden of regular return on the company.  It can retain money with it instead of distributing it among the investors. Thus the company can take risks and focus on establishing itself in the market. Due to heavy competition, the business needs some time to create its own recognition in the market in its initial stages. When it generates handsome revenue, it will compensate the investors for the risks taken by them.

2. No Liability

If the business does not succeed, the business doesn’t have any burden to repay anything to the shareholders. The owners will share the loss. The personal property of the entrepreneur is not liable in any way.

3. Professional Help & Advice

A startup, through equity financing, can get a partner, who will, apart from infusing funds, will be a partner in running the business. Angel investors therefore often help the startup in many ways like business advice, etc.

Cons:-

1. Interference In Business Management

Equity shareholders, due to their ownership and voting rights in the business, have a say in the day to day activities of the company. They also affect how the business’s spending decisions.

2. Dilution Of Control

Issuing more equity shares for additional financial requirements dilutes the ownership and control of existing shareholders.

3. Costly Source Of Capital

The cost of equity capital is much higher than any other sources of capital.[discussed below]

Cost of equity is the cost of raising funds by the issue of equity shares. There are several methods to measure the cost of equity. As per the dividend pricing method, cost of equity is the dividend expectations of the shareholders and is measured by the following formula

Ke = D/P

Where Ke = cost of equity

D =current dividend per share

P = current market price per share

Since equity shareholders undertake higher risk as compared to other classes of shareholders and holders of debt securities, they demand high dividend as compared to the interest paid on debt.

The impact of risk on the cost of equity is rightly justified by the Capital Asset Pricing Model (CAPM).

According to this method,

cost of equity = Risk-free rate of return + Risk premium

i.e. Ke = Rf + β (Rm – Rf)

where  Ke = Cost of Equity

Rf = Risk-free rate of return such as return on gilt-edged securities.

Β = beta coefficient

Rm = Rate of return on market portfolio i.e. expected return of the market

(Rm – Rf) = Market Premium i.e. the excess of market return over risk-free rate of return

Hence this model conveys that equity dividend consists of return on risk-free securities having negligible or no risk. And secondly, the risk premium for compensating the shareholders for the risks undertaken by them.

How Does Equity Financing Work?

Equity financing is done by selling common equity shares as well as preferred stock. A startup is financed in different rounds of equity financing in the process of its evolution.

For example, the entrepreneur himself holds the common equity shares in the business. Angel investors and venture capitalists usually invest in the venture in exchange for common equity or convertible preferred shares. Now the question is how to find angel investors.

Industry-focused events provide the opportunity to meet angel investors. With the emergence of technology, you are now able to find angel investors globally by going online. You can then set up meetings with them and pitch your ideas to potential investors in your area. Some examples of these websites are:

https://gust.com/

http://ww7.usangelsinvestors.com/

Once the company grows larger enough to consider going public, it has to get registered with a recognized stock exchange. Then it has to prepare a prospectus, get it registered and issue it to the public. The prospectus, as an invitation to offer for subscription for securities, informs important things about the company to the public. Such information includes the activities of the company, details about its directors and officers, its past financial statements, the purpose for which the money to be raised will be utilized. Hence the prospective investors can make informed decisions regarding the risk involved in it and whether it is suitable for him.

The entire process of Initial Public offering has to be in compliance with the regulations of the security authority of the country.

For further expansion programmes, the company can make a right issue of shares to its existing shareholders.

However, a private company is not eligible to offer its securities to the public. Hence it has to issue private placement offer letter to invite known persons for subscribing to the shares of the company.

Debt Financing:

Pros:-

1. Cheap Source Of Capital

As debt securities carry the lesser amount of risk as compared to shares, the cost of debt (Kd) is usually lower than the cost of equity (Ke).

Cost of debt is the effective rate of interest paid by the company on its borrowings. It is most of the time referred to as the after-tax cost of debt. It is calculated as follows.

In case of irredeemable debt,

Cost of Debt (Kd) = Interest(1-tax rate)/Net proceeds from the debt

In case of redeemable debt,

Cost of Debt (Kd) = [Interest(1-tax rate)+{(RV-NP)/N}] / [(RV+NP)/2]

Where    RV = Redemption Value of the debt at its maturity

NP = Net Proceeds from the debt

N = Term or the life of the debt

2. Tax-Deductible Expense

Interest on debt is a tax-deductible expense. Hence the company can save in terms of tax by raising funds through debt securities while meeting its financial requirements.

Thus debt provides a tax shield.

The net taxable profit is calculated as EBIT (Earnings before interest & taxes) – (Interest on debt)

3. Predictable & Stable Financial Charge

The rate of interest is fixed at the time of availing the loan. The company has to pay a fixed and known amount of money as interest at each agreed periodical interval.

Since the company is aware of the fixed financial charges, it can arrange its activities accordingly and target to earn a profit that will cover the finance charges.

4. No Interference In Business Management

Lenders do not have any stake in the ownership of the company and hence no say in the operations of the company. As long as you pay the dues timely, they will not interrupt in your business.

5. Trading On Equity Advantage

The main objective of the management is to maximize the value of the business by maximizing the earnings available to shareholders. So that EPS is optimized and the shareholders are happy. This is facilitated by optimal utilization of debt in the capital structure. This phenomenon is commonly referred to as trading on equity.

Let’s understand the concept with the help of an example.

Suppose, the EBIT of a company for a particular year is $ 8,00,000. The company has 2,00,000 existing equity shares of $ 10 each. It further requires $ 5,00,000. With the additional finance, the company is expected to have a total EBIT of $ 10,00,000. There are two financing propositions before the company.

  1. Issuing 50,000 additional equity shares of $ 10 each. Or
  2. Obtaining $ 5,00,000, 14% loan from a bank.

If the company accepts the first proposition, the EPS will be $10,00,000/2,50,000 shares = $ 4 per share.

But if it opts for the second one, the EPS will be ($ 10,00,000 – 14% of $ 5,00,000)/2,00,000 shares = $ 4.65 per share.

Thus we see that using debt helps to maximize shareholders’ earnings. This example ignores corporate tax. But in real-world situations where there is a corporate tax, the company can avail tax shield while trading on equity.

However, there are certain restrictions on the use of use debt in the capital structure. Excess borrowing makes the company a debt trap.

6. No Dilution Of Control

The issue of debt securities to meet additional financial requirements does not dilute the ownership and voting rights of the existing shareholders. Hence the ownership is kept intact.

Cons:-

1. A Fixed & Regular Financial Burden

Taking debt creates a fixed burden on the company to pay regular interest. Especially if the company is not making sizeable profits or is running at a loss, the matter becomes more grave. Failure to meet the dues timely affects the financial standing of the business and also invites legal prosecutions.

2. Financial Risk

Using excess debt in the capital structure also discourages equity investors. This is because there is a risk that all the earnings of the company may be utilized for the payment of interest and nothing or very less may remain for the equity investors.

3. Need For Security

Loans are mostly secured against tangible or intangible assets of the business. But no security is to be given on the issue of shares.

How Does Debt Financing Work?

A company can raise the debt by selling debt instruments such as debentures, bonds, notes, or bills to retail or institutional investors.

It can also avail direct loan from banks or other financial institutions. Selling debentures or bonds involves the same process as the issue of shares. In order to avail direct loans from a bank or other financial institution, there are some fixed procedures.

First of all, a qualified CPA (for the US) shall be called upon who will prepare projected financial statements of the organization for a certain number of future years on the basis of its past performance. All the required documents are to be submitted with the financier to complete the application process. After checking the eligibility and examining the creditworthiness of the company, the financier will approve the loan. The company is also required to provide primary and collateral security for availing a loan.

A company undergoes debt financing because it doesn’t have to put its own money at risk and certain other advantages that it carries. However, using too much debt is also risky and the company has to decide the right debt and equity mix in the capital structure (Debt to Equity Ratio).

As a thumb rule, the total debt of the business should not exceed twice the equity capital.

What are your thoughts on the pros & cons of equity & debt financing? Please comment below. 

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