Explaining Debt and Equity Financing
Debt financing is securing repayable interest-based loans from banks and other financial institutions whereas equity financing is obtaining money from investors such as individuals or venture capitalists in exchange for an ownership share in the business. Making the trade-off between debt financing vs equity financing is an important financial consideration as both have far-reaching implications.
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The major advantage of debt financing vs equity financing is the entrepreneur retains control over the business. Debtors have no say in the running of the business, and cannot question the management regarding their investment decisions or operation style.
In equity financing, the promoter sells shares of the company to raise funds for investment. Shareholders have the right to attend board meetings, elect the board of directors, and question the management on all aspects of the business. Any major investment decision requires the approval of a majority of the shareholders.
The promoter will ideally need to match the investments of others. If the share of investment exceeds the promoters own contribution, a group of investors holding more than 51 percent of the total shares can oust the promoter from the board and gain control of the company.
Statutory compliance is another area where debt scores over equity finance.
While securing equity capital is possible through private placement of shares to angel investors, venture capitalists, and other individuals, the most common and reliable way to do so is by listing the share in the stock exchange. Such public listed companies have to fulfill a host of statutory compliance measures such as holding annual general body meetings and director board meetings, issue notices and reports on a regular basis, subject the accounts to audit, and the like. Debt financing has no such requirements.
Debt financing also allows for tax savings on the interest paid; the tax is an expense deduction, where the gains from equity attracts tax.
The major advantage of equity capital over debt capital is that equity capital is not repayable. The investors share the profit or loss, as the case may be, expect to recoup their investments from future profits. Investors wishing to exit the business need to sell their stake to others, and the company is not obliged to repay the investment.
Debt capital mandates repayment of a fixed amount irrespective of whether the company makes a profit or less, and can be the death-knell of a company if the state of the economy goes from bad to worse, or if interest rates go up and cause the monthly installments to eat into the company’s capital base or cash flows. Nonpayment of the debt puts the company’s assets and the collateral security, usually the promoter’s personal assets, at risk.
A related benefit of equity financing is investors watching over the actions of the management forcing sound and efficient business principles. In contrast, the easy availability of unsupervised funds from debt might temp profligacy.
Most companies take recourse to both debt and equity to fund their operations.
The debt-to-equity ratio denotes the proportion of debt and equity in a company. The optimal debt: equity ratio depends on the circumstances, but as a rule of thumb, is between 1:1 and 1:2, or debt being less than 50 percent of the total equity base.
Companies usually resort to equity finance at the nascent stage of operations due to:
- Possibility of irregular cash flows hampering regular repayment of loan installments
- The ease of attracting investors based on proposed figures rather than on actual past results
- Reluctance of a financial institute to offer loans to new companies with no track record
A good debt equity increases the credit ratings of the company, as it denotes:
- A business run on sound principles with the backing of solid investors
- Availability of cash or assets to repay the debt in the eventuality of downturn
These are just some of the advantages and disadvantages of debt financing vs equity financing.