Most companies use a combination of debt and equity financing, but there are some distinct advantages of equity financing over debt financing. Principal among them is that equity financing carries no repayment obligation and provides extra working capital that can be used to grow a business.
Companies usually have a choice as to whether to seek debt or equity financing. The choice often depends upon which source of funding is most easily accessible for the company, its cash flow, and how important maintaining control of the company is to its principal owners. The debt to equity ratio shows how much of a company's financing is proportionately provided by debt and equity.
The main advantage of equity financing is that there is no obligation to repay the money acquired through it. Of course, a company's owners want it to be successful and provide equity investors a good return on their investment, but without required payments or interest charges as is the case with debt financing.
Equity financing places no additional financial burden on the company. Since there are no required monthly payments associated with equity financing, the company has more capital available to invest in growing the business. But that doesn't mean there's no downside to equity financing.
In fact, the downside is quite large. In order to gain funding, you will have to give the investor a percentage of your company. You will have to share your profits and consult with your new partners any time you make decisions affecting the company. The only way to remove investors is to buy them out, but that will likely be more expensive than the money they originally gave you.
Debt financing sometimes comes with restrictions on the company's activities that may prevent it from taking advantage of opportunities outside the realm of its core business. Creditors look favorably upon a relatively low debt-to-equity ratio, which benefits the company if it needs to access additional debt financing in the future.
The advantages of debt financing are numerous. First, the lender has no control over your business. Once you pay the loan back, your relationship with the financier ends. Next, the interest you pay is tax deductible. Finally, it is easy to forecast expenses because loan payments do not fluctuate.
The downside to debt financing is very real to anybody who has debt. Debt is a bet on your future ability to pay back the loan.
What if your company hits hard times or the economy, once again, experiences a meltdown? What if your business does not grow as fast or as well as you expected? Debt is an expense and you have to pay expenses on a regular schedule. This could put a damper on your company's ability to grow.
Finally, although you may be an LLC or other business entity that provides some separation between company and personal funds, the lender may still require you to guarantee the loan with your family's financial assets. If you think debt financing is right for you, the U.S. Small Business Administration works with select banks to offer a guaranteed loan program that makes it easier for small businesses to secure funding. (For related reading, see "Should a Company Issue Debt or Equity?")
- The main advantage of equity financing is that there is no obligation to repay the money acquired through it.
- Equity financing places no additional financial burden on the company, however, the downside is quite large.
- Creditors look favorably upon a relatively low debt-to-equity ratio, which benefits the company if it needs to access additional debt financing in the future.