When a business’ financing requirements exceed the limits of its internal sources and cash flows from business operations are insufficient, it must then decide which type of external financing best suited to its needs. In other words, your business needs more money than you have, and it is time to find those funds to keep the business running and growing.
Below we outline a few key factors to consider when choosing between two main types of financing: debt financing and equity financing. Choosing the right type of funding for your business is as important as determining how much funding you need in the first place, and it is not a decision to be taken lightly.
Is Debt Financing Right for Your Business?…
Companies tend to seek debt financing so that its shareholders can avoid the need to inject further personal funds into the company, and to avoid the reduction in ownership percentage (equity dilution) that is associated with raising equity.
For your company, debt financing can also be cheaper than equity financing as interest rates on debt are typically far lower than the required returns that equity investors seek. For example, compare the interest rate that you would expect your bank to charge you for a commercial loan to the return a private equity investor would require based on the level of perceived risk of your company achieving its expected growth.
Additionally, debt financing has the potential benefit of being able to magnify your company’s returns on its investments. For instance, imagine paying 8% interest on a loan to acquire technology that improves your company’s efficiency ten-fold.
It is important to remember, however, that debt contracts outline fixed repayment terms; including interest, and any collateral security that your company must pledge for the financier to be willing to provide such a loan. As such, lenders have a vested interest in the company for as long as the debt is outstanding, with regularly contracted payments and a senior ranking to equity holders in the capital structure.
Taking on additional debt thus also means taking on additional risk of financial distress or bankruptcy. This refers to the cost that can be incurred if your company experiences difficulties to meet its payment obligations with your lenders. These costs include bank fees, legal fees, and reputational damage to name a few.
Debt ownership in a shaky enterprise means control, for when a company fails to meet its interest payments, a bondholder can foreclose and liquidate the company
― Michael Lewis, Liar’s Poker
Or is Equity Investment a Better Bet?…
Equity investment, on the other hand, is inherently intended to be patient and long-term in nature, and may be a more appropriate funding source.
The total or enterprise value of a company comprises the value available to debt holders and the value available to equity shareholders. To determine the value available to the equity shareholders, the value of the company’s outstanding debt must be deducted from the company’s enterprise value. As a result, the larger your company’s debt balance outstanding, the lower its value available to you and the other equity shareholders.
Despite its higher cost by means of required return to investors, your company would be well advised to also seek equity capital for the following reasons:
- You may not reasonably have any further debt capacity; and/or
- Your shareholders may prefer the added flexible, less restrictive nature of equity capital, relative to debt.