Businesses need finance, either to expand an already existing business, or to start a new one. There are three alternatives for financing a business, namely, self financing, equity financing and debt financing. Self financing involves a huge risk and is generally taken up by small business owners. That leaves us with the other two financing methods, that is, debt and equity financing. Let's compare these financing methods on various counts, but before that it's important to understand their meaning.
Definition
Debt financing means when a business owner, in order to raise finance, borrows money from some other source, such as a bank. The business owner has to pay back this loan or debt within a pre-determined time period along with the interest incurred on it. The lender has no ownership rights in the borrower's company. Debt financing can be both, short term as well as long term.
Equity financing means when a business owner, in order to raise finance, sells a part of the business to another party, such as venture capitalists or investors. Under equity financing, the financier has ownership rights equivalent to the investment made by him in the business, or in accordance with the terms and conditions set between him and the business owner. This is the main difference between the two financing methods. In equity financing, the financier has a say in the functioning of the business as well.
Comparison
Process: Procedure of raising money through debt financing is easier, than raising money through equity financing. In equity financing , there are a number of security laws and regulations, which have to be complied by the business. Such rules are not applicable for debt financing.
Ownership Rights: In debt financing, the business owner has full control and ownership of the business. In equity financing, the investor or the venture capitalist has ownership rights, as well as decision-making power, in running the business.
Rights over Profit: In debt financing, the lenders only have a right over the principal loan and the interest incurred on it. They have no rights over the profits or revenues generated by the business. Once the loan is repaid, the relationship between the lender and the business owner also, ends in debt financing.
Ease of doing Business: In debt financing, decisions and rights regarding running the business, solely lie with the owner. Whereas in equity financing, the shareholders and investors have to be updated and consulted about the business regularly. So, it is easier to do business with debt financing, than with equity financing.
Repayment : In debt financing, the business debt has to be paid back within a given period of time. If for some reason, the business does not make enough profits or is going through a loss, there is a lot of pressure on the business owner to repay, as an increased time period of repayment means an increased interest on the loan. As far as equity financing is concerned, the pressure to repay is comparatively lesser. The revenue which the business makes is used to repay the lenders.
Cost to Company: In debt financing, the loan amount is already known and fixed, so the business owner can make a provision for it beforehand. Also, the interest incurred on loan in debt financing can be deducted from the corporate tax . Thus, cost to company in debt financing is easy to forecast, plan and reimburse. On the other hand, in equity financing, if the business generates huge profits, the investor and the venture capitalist have to be paid back money, which is much in excess of the amount they invested.
Future Funding: If the investors are backing the business, there will be no problem in arranging finance for the business in future, as investors lend credibility to a business and lenders will have no reservations in giving loans to such businesses. Thus, equity financing improves the scope of arranging financing for the business in future. However, if the business has taken too much loan, that is, its debt to equity ratio is on a higher side, the investors will not like to invest in such a business as it's a "high risk" venture.
Thus, it can be concluded that both have their pros and cons. Ideally, a business should have a mix of debt and equity financing with the debt amount comparatively low, so that debt management becomes easy. However, it's up to the owner of the business to decide where his preferences lie. A business owner who wants full authority over the business, should choose debt financing.While an owner who is willing to share his risks and profits should opt for equity financing.
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