Debt Vs Equity Finance -What’s Best for Your Business?

It is common for entrepreneurs to need more funding in order to grow their businesses, develop novel products, employ more staff, acquire raw materials, etc. While companies seeking to finance their expansion, have a variety of funding options at their disposal, the one of the initial decisions leaders have to decide is whether to pursue debt or equity.

However, what differentiates debt financing from equity financing? What is the best option for a business among these? Continue reading to learn more about the key distinctions between debt and equity financing, including its pros and cons, and more.

Debt Financing for Expanding Businesses

Debt financing is the process of raising funds for a business through borrowing out loans from outside sources, usually in the form of bonds issued to investors or loans from financial institutions. The lending terms and conditions such as applicable interest rate, repayment term, and any collateral requirements, rights of the parties, etc. are clearly outlined in the contract between the lender and borrower. The individuals or institutions lending funds become creditors of the company with assurance to repay the debt (principal and interest) over the stipulated period. 

Key Features of Debt Financing 

• Ownership-In the case of debt financing, the company’s ownership remains unaffected. The lenders have little influence over the business.
• Interest Payments- The cost of borrowing money represents interest payments charged on business loans obtained through debt financing.
• Covenants- Usually included in loan terms, covenants might take the manner of monitoring covenants or, occasionally, financial covenants.
• Tax benefits- Interest payments can dramatically reduce taxable income as they are tax deductible under the provisions of Income Tax Act 1961. 
• Collateral required- Borrowers are often required to sign over a physical asset, such as business investments, stock or machinery, etc. as a guarantee for timely repayment of business debt. 

Pros of Debt Financing in Comparison with Equity Financing

1. No impact on business ownership- Debt financing allows an organization to leverage funds towards an organization’s growth and development without the risk of losing control or diluting ownership.  Thus, an organization could function autonomously without intervention from external parties.
2. Tax Benefits- Interest payments on borrowed funds are allowed as deductions which significantly lowers cost of organization. It acts as a financial incentive potentially improving a business’s financial success.
3. Simple Transaction process- Debt transactions are far lesser complex and faster to execute to secure funds quickly as compared to often intricate and time-consuming processes involved in issuing equity (i.e. IPO and private placements,). 
4. No post repayment obligations- The borrower and lender’s contractual relationship essentially ends when a loan is entirely repaid, including principal and interest. Later, the lender has no further claim over the business’s future profits, assets, or decision-making procedures.
5. Low-cost capital- During instances such as low cost of borrowing or businesses with strong credit profiles, the cost of debt could be significantly lower than the cost of equity. It makes debt financing a sound choice for raising business funds. 
6. Allows flexible funds usage- Unlike equity financing, Debt financing allows organizations to employ funds as per their requirements without external pressure. 

Cons of Debt Financing Vis a Vis Equity Financing

1. Risk of overleveraging- Businesses with higher levels of debt have the risk of overleveraging through debt financing. Such a high level of risk might affect its overall financial status apart from creating a negative image among investors and creditors. 
2. Covenant Restrictions– Most debt financing agreements come with certain restrictions and limitations. These constraints jeopardize an organization’s autonomy and management capabilities. Inability to keep up with the covenants, on the other hand, may result in significant penalties or accelerate the debt recovery process.
3. Asset Collateralization- Secured loans require submission of collateral for securing repayment. Failure to repay debt gives the lender the right to confiscate the same. If the lender exercises the right, it could cause disruption in business activities and resort to liquidation. 
4. Reduces Future Borrowing prospects- Excessive debt levels might hinder a business’s capacity of obtaining more capital whenever required either through raising the cost of borrowing capital or by completely closing off access to credit markets.
5. Risk for seasonal businesses/ unstable market conditions- Businesses functioning across seasonal industries or unstable markets face financial challenges due to limited or no income during off-seasons making it difficult to repay loans and thus prone to insolvency. 
6. Limited access for early -stage businesses- Startups and business units functioning within high-risk sectors might lack access to debt financing or those who do might have to bear unaffordable interest rates.
7. Administrative Complexity- Managing a debt profile requires extensive documentation, continuous compliance audits, and continual interactions with lenders, all of which make business operations even more challenging.

Equity Financing for Expanding Businesses

Equity financing is a means for obtaining business capital by transferring shares of an organization entity to individuals or companies who then become shareholders of the businesses. It entails the selling of equity instruments, including common shares, warrants, convertible preferred stock, and preferred stock. Investors benefit either when the value of shares rises or when the company pays a dividend to them. Equity financing is especially relevant for start-ups requiring funds to achieve its growth and expansion objectives.  

Key Features of Equity Financing

• No Repayment Obligation- Unlike debt financing, there is no obligation for the company to repay the investment amount or pay any interest amount as the investors are betting on the company’s growth.
• Ownership Dilution- Equity financing entails giving up control in exchange for the funds.
• No Tax Benefits- Unlike debt, equity financing doesn’t offer tax-deductible benefits.
• Long-Term Commitment- Compared to debt financing, equity financing demands patience on the part of the investors expecting business growth rather than expecting immediate returns.

Pros of Equity Financing in Comparison with Debt Financing

1. Alternative source of financing- Equity financing provides an alternate means of financing for businesses rather than just sticking to debt capital. Small scale businesses or start-ups failing to fulfil eligibility criteria for conventional bank loans could seek capital from investors acquiring equity in the company. 
2. Improved Credibility and Valuation- Raising equity capital can boost a company’s market valuation and improve financing prospects in future. 
3. Minimizes risk- Unlike debt financing, there is no obligation on the company to make 

regular interest payments to the investors. It enables the company to steer clear from the risk of repayment default or insolvency risks allowing a healthy debt-to-equity ratio and more stable financial position. 

1. Operational autonomy- As compared to debt agreements with certain restrictions, equity financing agreements allow more operational autonomy to the company as the terms negotiated with the investors. 
2. Comes with additional benefits for enterprise growth- aRather than just offering business capital, equity financing offers valuable expertise from the investors and access to industry connections which offers necessary support for business growth and expansion. 
3. Future funding prospects- Successfully securing equity financing for a company helps to improve a credit profile and financial health which helps to enhance its funding opportunities.  

Cons of Equity Financing Vis a Vis Debt Financing

1. Dilution of ownership and operational control- In order for a new investor to become shareholder in a company, the existing owners need to relinquish a portion of their holding, which means loss of rights, profits distribution, and control over business decisions. This is the primary disadvantage of equity financing. 
2. No tax benefits- Equity investments, as opposed to debt funding, do not provide any tax benefits. Shareholder dividend payments are not deductible from taxes. It raises the cost of overall equity financing for the company.
3.  Autonomy Loss- When a business accepts additional equity partners, it frequently gives up some level of strategic and operational autonomy. Investors committing larger amounts also seek greater power in decision-making and business functioning which leads to loss of autonomy for the company and minor shareholders.
4. Complex processes- Issue of shares frequently involves extensive regulatory requirements from fulfilling compliances and reporting to authorities which makes it a more complicated process than debt financing. 
5. Lengthy process- Irrespective of whether the funds are raised through private placements or initial public offerings, equity financing requires a series of activities from board meetings to paperwork filing with authorities. Fulfilling such lengthy processes may demand more attention and expenses, potentially diverting leadership attention away from core business operations.
6. Public Scrutiny- With greater visibility and regulatory constraints, companies that go public may invite greater observation from investors, economists, and the media, which could have an impact on their manner of operation and their public image.
7. Hostile Takeover Risk- As a result of dilution of ownership stakes and open market shares, a public company might be prone to risks of hostile takeover particularly where the shareholder base is dispersed.
8. Higher capital cost- It is possible that equity financing might cost higher than debt financing for the business organization. It is for the simple reason that since investors take on huge risk when investing in a company, they demand a higher return.

Difference between Debt Financing vs Equity Financing

Aspect	Debt Financing	Equity Financing
Definition	It is the process of borrowing funds from lender/creditor for fuelling business interest which must be repaid along with interest.	It is the process of raising funds from investors through sale of equity shares to the company in exchange of funds.
Ownership	It does not result in any transfer of ownership rights to the lender.	Post acquiring shares of a company, investors gain ownership rights in a company.
Repayment obligation	The borrowed amount must be repaid within the pre-agreed term.	There is no obligation on the company to repay the amount invested.
Cost	Regular interest payments	Dilution of ownership stake.
Control	Lenders hold no authority over business decisions.	Equity investors have authority to participate in business decisions.

Debt Financing vs Equity Financing- Which is better for business?

When it comes to choosing between equity financing and debt financing for a business, there cannot be one answer. It may depend on various factors including financial health of the business, its goals and objectives, and the willingness to lose control from the existing shareholders. 

Factors to Consider when Deciding Between Debt and Equity Financing.

1. Growth stage- Start-ups going through pre-revenue state, equity financing might be more logical. It will allow the business to function effectively without the stress of repayments. However, if the business is generating uniform cash-flows, accessing debt financing will help to grow without too much interference on business decisions. 
2. Risk Tolerance- Businesses struggling with irregular cash flows might benefit from equity financing since choosing debt financing will mean meeting timely repayments in any situation and vice-versa. 
3. Willingness to lose control- If the initial shareholders do not wish any external influence over business decisions, then debt financing would be a good choice. However, if they are open to onboard new partners who can offer expertise and industry connections, equity financing would be a better decision. 

Conclusion

Therefore, debt and equity financing are both effective ways for businesses to raise funding, and each has positive and negative aspects. While debt financing is a good option for companies that have consistent cash flows since it allows for prompt repayments, companies with erratic cash flows that aim to grow over time should think about equity financing. Apart from this, companies should make an effort to keep a healthy debt-to-equity ratio since it can enhance capital structure, reduce risk, and spur expansion.

FAQs

What is the difference between Debt and Equity Financing?

Debt involves borrowing money that must be repaid over time with interest and without loss of control or ownership. While equity involves raising of funds by selling ownership shares in the company, with no obligation to repay, but loss of control and part ownership.

What’s more suitable for startups – debt or equity financing?

For Start-ups going through pre-revenue state. equity financing might be more logical. It will allow the business to function effectively without the stress of repayments. However, if the business is generating uniform cash-flows, accessing debt financing will help to grow without too much interference on business decisions. 

What is the cost of equity financing compared to debt financing?

Equity is often more expensive in the long run because: Investors demand higher returns, there are no tax benefits and ownership has been diluted which may affect the speed of decision making time lag.

Can a business choose both debt and equity financing?

Yes, most businesses thrive on regular cash flows from debt and also choose to raise capital through equity therefore getting the benefits of both – maintain a balanced capital structure, benefit from both methods, and reduce financial risk.

Does debt and equity financing give tax benefits to the companies?

Interest payments made on business loans are generally tax-deductible but equity investments do not provide any tax benefits. We at BanKeeping can partner an SME’s loan journey and hand hold the business through its application, negotiations and even management of the credit cycle. Bankkeeping decodes sanction terms, calculates real Drawing Power, and simulates credit rating, enabling SMEs to negotiate smarter and take control of business loans. Click here for a demo that can change the way SMEs bank. BankKeeping have sophisticated tools and a highly advanced loan management system for SMEs.