Debt and Equity financing are both ways employed by business owners to finance their business. ‘Finance’ in this sense simply refers to funds required by businesses to carry out its various activities. Without a doubt, a business cannot function without the adequate funds made available to it. In other words, finance can be likened to the lifeblood or linchpin of any business.
As a prospective entrepreneur, the need for funds arises from the moment one sets out to start a business. This is known as the initial capital. More often than not, the initial capital needed to take care of all the financial requirements to start a business may not be readily available to the entrepreneur. Some other immediate needs for business include purchase machinery, land and buildings, furniture and other fixed assets. An entrepreneur determined to run a business organization, therefore, needs to search for avenues where his financial needs can be met. This implies that a clear assessment of his financial needs and the understanding of the sources of finance is imperative to the successful running of a business.
As the need for financing rises not only at the start of a business but also at any stage of the business, some funds are required for the daily operations of the business such as purchasing raw materials, transportation, salary of employees, among others. It should also be borne in the minds that before seeking capital to grow a business, there is a need to know where to find debt and equity financing, factors to consider, and which of the two types an entrepreneur qualifies for, as well as the pros and cons of each.
SOURCES OF EXTERNAL FINANCING
The various types of external financing for a business organization can be classified into two categories: Debt Financing and Equity Financing.
Debt Financing involves any form of financing secured through borrowing or loans, which is usually paid back with interests.
Borrowing is one of the most common ways any enterprise or company or even the government can secure the funds needed. Against this background, debt financing occurs in a situation where a lender provides an entrepreneur with the capital needed for business which must be paid back after a particular period, with interest. Simply, debt financing is any type of loan that a business uses to finance any of its operations. This method of financing is what most people find familiar. Debt Financing takes different forms; the specific circumstances of each entrepreneur determines the type of debt financing to be adopted. The most prevalent types include:
This is the most basic form of debt financing. It is a sum of money an organization borrows that must be repaid over a specific period with interest. Based on the set period, a loan can be either a Long-term loan or Short-term loan.
Long-term loans are typical loans an entrepreneur secures from a bank, to be repaid over several years. These loans are usually granted for a large established business with a good credit history. Short-term loans, on the other hand, are usually paid back in a few months or within a year or two. Short-term loans offer quick cash to borrowers with less stringent background credit checks. This type of loan favours smaller businesses. One of the major differences between long-term and short-term loans, aside from the pay-back period, is the amount issued. It is a rule of thumb that the higher the loan amount the longer it will take to offset.
Trade credit is a business to a business agreement. This is a type of credit given to a business owned by a supplier who allows them to buy now and pay later. Trade credit occures anytime one takes delivery of goods or materials without any upfront payment. Depending on the terms of the credit extended by the supplier, the cost of trade credit can either be low or high. Discounts are also available depending on the terms of the agreement. This credit is usually extended to customers who have a good financial standing and goodwill. However, it is not impossible to secure a trade credit as a start-up, sharp negotiation skills and a practical financial plan can help secure a trade credit.
An instrument issued by a company that either creates a debt or acknowledges it is a debenture. Debentures are usually unsecured in nature, though it can be secured. It is considered as secured when the debt is guaranteed by a charge over the assets of the company, making it possible for the creditor to recover his money if the debtor is unable to pay.
Debentures appears in the following shades:
- Perpetual: Debentures of this nature are intended to be permanent, which means that the debenture can only be redeemed on the occurrence of an event or after a set time.
- Convertible: These are debentures that have the option to be converted into equity shares of the company, depending on the terms of the agreement.
- Registered: These are debentures that are recorded in the register of debentures holders and only payable to those contained in the register.
- Bearer: Debentures of this nature are transferable by mere delivery i.e. they are payable to whoever presents them for payment.
- First and Second: These are debentures that must be repaid first before other debentures. The second debentures come after the first debentures have been repaid.
PROS OF DEBT FINANCING
- The biggest advantage of subscribing to debt financing is the retention of ownership and control over one’s business. There is no fear of any hostile take-over. The decision making and profit-sharing lie solely on you.
- Debt financing can be applied to any kind of business, at any stage and size.
- The interest payment on the debt is tax-deductible from the firm’s tax return.
- The interest rates on loans are relatively lower than returns on equity investments.
CONS OF DEBT FINANCING
- The most significant disadvantage is the need to repay both the principal and interest, regardless of your business making profit or loss. Having to pay monthly debt payments can be a huge burden on the growth of start-ups.
- The risk of defaulting can put your business at a major risk of losing it or certain assets. One’s home, cars, private funds can all become collateral damage.
- As lenders aren’t invested in your success, they usually do not support the business with their input, unlike equity investments. The risk is not shared.
- Most times debt instruments contain clauses that restrict the use of the debt for non-core objectives of the company and pursuing other financings elsewhere.
Equity Financing borders on the sale of a percentage of a business to an investor in exchange for capital. It is largely different from debt financing in that it deals solely with entrepreneur’s ownership interests in the company i.e. investors have an ownership stake in a company. There is an exchange of the investor’s funds for a percentage of a company’s financial interest. There are no fixed regular payments to be made to your investors as you would with a lender. The investors share in the risk of the business whether it is successful or not. This is why investors favour innovative start-ups with high potential to generate a huge return on investment.
TYPES OF EQUITY FINANCING
Equity financing comes in several different types. However, it typically from the following three sources:
These are firms that are willing to invest millions into promising companies with high returns. Venture capitalists are in the business of investing in companies. However, most small businesses are not of much interest to them. Venture capitalists mostly favour innovative tech start-ups like Uber, among others.
These investors, much like Venture capitalists, are willing to invest money into a business with high return potentials in exchange for a percentage of ownership. The difference lies in the fact that angel investors are generally private individuals with high net worth, who invest with their money. Examples of angel investors are family members, friends, colleagues, acquaintances, even a total stranger.
This is the process of generating funds for a business or project from a large number of people where each contributes a relatively small amount, usually through online platforms. Method of financing can be philanthropic in nature i.e. the contributors may not get any reward. Some offer a reward like a discount on the new product or free of charge for their contributors. Some offer a small percentage of equity in the business.
PROS OF EQUITY FINANCING
- Less risk: The risk of running the business is shared with the investors. Whether the business makes a profit or not, the burden is shared by the investors. This favours start-ups that are yet to attain profitability in the early stages.
- No fixed time for repayment: The amounts invested by various investors need not be paid back, as in the case of debt financing. The investors receive their returns on their percentage of investment only if the business succeeds.
- Long -term: Equity investors do not expect to receive an immediate return on their investment.
- Connections: Asides, financial contributions investors tend to contribute in other means like ideas, relevant connections, publicity. Since investors are financially invested in the business, the success of it is their key concern.
CONS OF EQUITY FINANCING
- Control: With equity financing, the owner has to give up some control over their company when they take on investors. Equity investors are stakeholders and must be carried along in the decisions concerning the company.
- Potential for Conflict: Conflicts could easily arise in decision-making with investors. This is why it is advised to take on investors that share the same vision with the owner. In some cases, investors could take over the company from the owner, this is referred to as a hostile takeover.
- Getting Investors: Landing investors to invest in your company could be frustrating, as investors are not readily available. It requires proper planning to invite and win over investors to join your company, especially as a start-up.
FACTORS TO CONSIDER WHEN CHOOSING BETWEEN DEBT AND EQUITY FINANCING
Without a reliable source of financing, a business is bound to fail. Thus, if you are looking to start a business, it is important to find out what kind of financing is beneficial to the success of your business. To achieve this, the following factors must be properly considered by any prospective business owner:
- The current business structures and the existing framework would surely influence your short-term financial decisions.
- Long-Term Goals- Where do you envision your business in the next ten to twenty years? By answering this question, it becomes clearer how to financially entrench your business.
- The Need for Control- If the need for total control over your business is paramount to you, debt financing might be best or limiting amount of equity distributed.
- Borrowing Requirements- These requirements can often be stringent. Most lenders consider your equity to debt ratio, low debt to equity ratio is considered most favourable.
Both debt and equity financing have their advantages and disadvantages, as has been argued. To find the right fit, entrepreneurs need to consider the nature of their businesses. The key advantage of equity financing is there is no obligation to pay back funds acquired through it. However, entrepreneurs can lose grip of total control. But with debt financing, they acquire the necessary funds while retaining control, although such funds must be paid back with interest at a set time. In light of the above, a mixture of both debt and equity financing may be better tailored to the entrepreneurs’ specific needs.