What Is Financing?
Financing is the process of providing funds for business activities, making purchases or investing. Financial institutions such as banks are in the business of providing capital to businesses, consumers, and investors to help them achieve their goals. The use of financing is vital in any economic system, as it allows companies to purchase products out of their immediate reach.
Put differently, financing is a way to leverage the time value of money (TVM) to put future expected money flows to use for projects started today. Financing also takes advantage of the fact that some will have a surplus of money that they wish to put to work to generate returns, while others demand money to undertake investment (also with the hope of generating returns), creating a market for money.
[Important: While equity and debt financing are the most common, there are other ways to finance a business—such as informal financing from friends or family. Most recently, blockchain-based token financing has been one alternative avenue to raise capital.]
There are two main types of financing available for companies: debt and equity. Debt is a loan that must be paid back often with interest, but it is typically cheaper than raising capital because of tax deduction considerations. Equity does not need to be paid back, but it relinquishes ownership stakes to the shareholder. Both debt and equity have their advantages and disadvantages. Most companies use a combination of both to finance operations.
Types of Financing: Equity Financing
"Equity" is another word for ownership in a company. For example, the owner of a grocery store chain needs to grow operations. Instead of debt, the owner would like to sell a 10% stake in the company for $100,000, valuing the firm at $1 million. Companies like to sell equity because the investor bears all the risk; if the business fails, the investor gets nothing.
At the same time, giving up equity is giving up some control. Equity investors want to have a say in how the company is operated, especially in difficult times, and are often entitled to votes based on the number of shares held. So, in exchange for ownership, an investor gives his money to a company and receives some claim on future earnings.
Some investors are happy with growth in the form of share price appreciation; they want the share price to go up. Other investors are looking for principal protection and income in the form of regular dividends.
Advantages of Equity Financing
Funding your business through investors has several advantages, including the following:
- The biggest advantage is that you do not have to pay back the money. If your business enters bankruptcy, your investor or investors are not creditors. They are part-owners in your company, and because of that, their money is lost along with your company.
- You do not have to make monthly payments, so there is often more liquid cash on hand for operating expenses.
- Investors understand that it takes time to build a business. You will get the money you need without the pressure of having to see your product or business thriving within a short amount of time.
Disadvantages of Equity Financing
Similarly, there are a number of disadvantages that come with equity financing, including the following:
- How do you feel about having a new partner? When you raise equity financing, it involves giving up ownership of a portion of your company. The smaller and riskier the investment, the more of a stake the investor will want. You might have to give up 50% or more of your company, and unless you later construct a deal to buy the investor's stake, that partner will take 50% of your profits indefinitely.
- You will also have to consult with your investors before making decisions. Your company is no longer solely yours, and if the investor has more than 50% of your company, you have a boss to whom you have to answer.
Types of Financing: Debt Financing
Most people are familiar with debt as a form of financing because they have car loans or mortgages. Debt is also a common form of financing for new businesses. Debt financing must be repaid, and lenders want to be paid a rate of interest in exchange for the use of their money.
Some lenders require collateral. For example, assume the owner of the grocery store also decides that she needs a new truck and must take out a loan for $40,000. The truck can serve as collateral against the loan, and the grocery store owner agrees to pay 8% interest to the lender until the loan is paid off in five years.
Debt is easier to obtain for small amounts of cash needed for specific assets, especially if the asset can be used as collateral. While debt must be paid back even in difficult times, the company retains ownership and control over business operations.
Advantages of Debt Financing
There are several advantages to financing your business through debt:
- The lending institution has no control over how you run your company, and it has no ownership.
- Once you pay back the loan, your relationship with the lender ends. That is especially important as your business becomes more valuable.
- The interest you pay on debt financing is tax deductible as a business expense.
- The monthly payment, as well as the breakdown of the payments, is a known expense that can be accurately included in your forecasting models.
Disadvantages of Debt Financing
Debt financing for your business does come with some downsides:
- Adding a debt payment to your monthly expenses assumes that you will always have the capital inflow to meet all business expenses, including the debt payment. For small or early-stage companies that are often far from certain.
- Small business lending can be slowed substantially during recessions. In tougher times for the economy, it's more difficult to receive debt financing unless you are overwhelmingly qualified.
[Important: If a company fails to generate enough cash, the fixed-cost nature of debt can prove too burdensome. This basic idea represents the risk associated with debt financing.]
- 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, though the downside is quite large.
- Debt financing tends to be cheaper and comes with tax breaks. However, large debt burdens can lead to default and credit risk.
- The weighted average cost of capital (WACC) gives a clear picture of a firm's total cost of financing.
Special Considerations: Weighted Average Cost of Capital (WACC)
WACC is the average of the costs of all types of financing, each of which is weighted by its proportionate use in a given situation. By taking a weighted average in this way, we can determine how much interest a company owes for each dollar it finances. Firms will decide the appropriate mix of debt and equity financing by optimizing the average weighted cost (WACC) of each type of capital while taking into account the risk of default or bankruptcy on one side and the amount of ownership owners are willing to give up on the other.
Because interest on the debt is typically tax-deductible, and because the interest rates associated with debt is typically cheaper than the rate of return expected for equity, debt is usually preferred. However, as more debt is accumulated, the credit risk associated with that debt also increases and so equity must be added to the mix. Investors also often demand equity stakes in order to capture future profitability and growth that debt instruments do not provide.
WACC is computed by the formula:
- rE = cost of equity
- rD = cost of debt
- E = market value of the firm’s equity
- D = market value of the firm’s debt
- V = (E + D)
- E/V = percentage of financing that is equity
- D/V = percentage of financing that is debt
- TC = corporate tax rate
Example of Financing
Provided a company is expected to perform well, you can usually obtain debt financing at a lower effective cost. For example, if you run a small business and need $40,000 of financing, you can either take out a $40,000 bank loan at a 10% interest rate, or you can sell a 25% stake in your business to your neighbor for $40,000.
Suppose your business earns a $20,000 profit during the next year. If you took the bank loan, your interest expense (cost of debt financing) would be $4,000, leaving you with $16,000 in profit.
Conversely, had you used equity financing, you would have zero debt (and as a result, no interest expense), but would keep only 75% of your profit (the other 25% being owned by your neighbor). Therefore, your personal profit would only be $15,000, or (75% x $20,000).
[Fast Fact: With equity, the cost of capital refers to the claim on earnings provided to shareholders for their ownership stake in the business.]