Financing Decision: Debt vs. Equity

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Published by Chhaya Rana at June 17, 2018

Debt vs. Equity

Entrepreneurs come across the need for capital for multiple reasons. Aspiring entrepreneurs may seek funding to start their businesses, whereas growing businesses might need funding for expansion, purchase of assets or meeting working capital needs. Whatever the reason is, entrepreneurs face an ongoing need for funding which is generally fulfilled by two ways – debt financing and equity financing. Both financing options have their own advantages and disadvantages and the funding decision depends on the entrepreneur’s judgment, type and stage of the startup and the company’s future plans.

What is debt financing?

Debt is the amount of money owed by the borrower and needs to be repaid. Consequently, Debt financing involves borrowing funds from a lender. The lender could be close friends and family or financial institutions such as commercial banks and finance companies. It is characterized by fixed repayments along with interest charged against the borrowed funds.

Advantages

Disadvantages

Debt Financing enables retention of ownership, which means the lender has no direct claim on future profits as well as guarantees full control over management.
It is flexible and less complicated as there are several lending options available.
Forecasting expenses are easier because loan payments do not fluctuate.
It enables tax savings as interest is a tax-deductible expense.

Debt has to be repaid despite the condition of the business. There is pressure to make interest and principal repayments even when the business is suffering from financial distress.
Interest payments are a fixed cost.
Debt financing involves a level of risk as failure to pay back the debt can cost the assets pledged as collateral. It also negatively affects the credit rating.
The entrepreneur has to bear all the loss in case of bankruptcy and is obligated to repay the funds owed to the lender.
Since debt is an expense, it prevents reinvestment of revenue in the business.

What is equity financing?

Equity refers to ownership interest, usually represented by stocks or securities. Hence, equity financing refers to the process of raising funds through the sales of ownership of the company through shares.

Advantages

Disadvantages

There is no pressure for repayments of borrowed funds and no additional costs such as interest.
An equity partner or shareholder can provide more than just finance. They often bring with them valuable skills, contacts, and expertise to support the business.
Shareholders can also provide follow up funding to the growing business as per its requirement.
It allows minimization of risk and losses in the event of business failure as the investors share the losses incurred.

Raising equity financing is demanding and time-consuming. It may take several months to find appropriate investors.
Selling shares imply that one is giving up a percentage of their business, which results in diluted control over management decisions.
It requires additional time to provide regular reports and updates to the management.

Ultimately, the selection of appropriate funding depends on various factors. For a smaller amount of funds and cash urgency, debt financing would be a viable option. On the other hand, if the entrepreneurs are looking for more than just cash and do not mind sharing the ownership, equity financing could be a better choice. The funding decision can leave a lasting impact on the business and should be carried out after the thorough evaluation of the pros and cons of each option and the current situation of the business. Most companies utilize a combination of debt and equity funding for effective management of funds.

Investment Facilitation is one of Biruwa’s key services. If you are an entrepreneur seeking investment or an investor seeking for new investment opportunities, please refer our service page below:

Link to investment facilitation: https://biruwa.net/consulting/investment-facilitation/

Chhaya Rana

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Chhaya Rana

Chhaya Rana, Junior Associate at Biruwa is primarily invovled in Finance related assignments and also involved in writing and information gathering. She has completed her Bachelors in Business Administration(BBA) from Kathmandu College of Management.