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Debt Financing Vs. Equity Financing

Debt Financing Vs. Equity Financing

The following article on debt financing vs. equity financing will help you ascertain which is better of the two options to fund your projects.
Aastha Dogra
Last Updated: Jun 3, 2018
Businesses need finance either to expand an already existing business, or to start a new one. There are three alternatives to finance a business, namely, self financing, equity financing, and debt financing. The first option involves a huge risk and is generally taken up by small business owners. That leaves us with the other two methods. It is important to understand both of them and compare them on an equal level to get to know which one would be more suitable to choose while starting a business. On that note, read the article below on debt financing vs. equity financing.
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 within a pre-determined time period along with the interest incurred on it. The lender has no ownership rights in the borrower's company. This method can be 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 this method, 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 methods. Here, the financier has a say in the functioning of the business as well.
Comparison
Key Points Debt financing Equity financing
Process Procedure of raising money is easier, Certain rules and regulations are not applicable. Raising money is comparatively difficult, as there are a number of security laws and regulations, which have to be complied by the business.
Ownership Rights The business owner has full control and ownership of the business. The investor or the venture capitalist has ownership rights, as well as decision-making power, in running the business.
Rights over Profit 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. The rules function differently in this case.
Ease of doing Business The decisions and rights regarding running the business, solely lie with the owner, so, it is easier to do business. The shareholders and investors have to be updated and consulted about the business regularly. So, it is a bit complicated to do business.
Repayment 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. The pressure to repay is comparatively lesser. The revenue which the business makes is used to repay the lenders.
Cost to Company 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 can be deducted from the corporate tax . Thus, cost to company is easy to forecast, plan, and reimburse. Here, 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 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. 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, this method improves the scope of arranging finance for the business in future.
Thus, it can be concluded that both have their pros and cons. Ideally, a business should have a mix of both the methods, 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.