Debt vs. Equity Financing
Debt vs. Equity Financing
Equity financing takes the form of money obtained from investors in exchange for an ownership share in the business. Such funds may come from friends and family members of the business owner, wealthy “angel” investors, or venture capital firms. The main advantage to equity financing is that the business is not obligated to repay the money. Instead, the investors hope to reclaim their investment out of future profits. The involvement of high-profile investors may also help increase the credibility of a new business. Additionally, the company's assets do not have to be used as collateral to obtain equity, and the business does not have to make debt payments. The main disadvantage to equity financing is that the investors become part-owners of the business, and thus
gain a say in business decisions. “Equity investors are looking for a partner as well as an investment, or else they would be lenders,” venture capitalist Bill Richardson explained in Pacific Business News (Jefferson, 2001). As ownership interests become diluted, managers face a possible loss of autonomy or control. In addition, an excessive reliance on equity financing may indicate that a business is not using its capital in the most productive manner.
Both debt and equity financing are important ways for businesses to obtain capital to fund their operations. Deciding which to use or emphasize depends on the long-term goals of the business and the amount of control managers wish to maintain. Ideally, experts suggest that businesses use both debt and equity financing in a commercially acceptable ratio. This ratio, known as the debt-to-equity ratio, is a key factor analysts use to determine whether managers are running a business in a sensible manner. Although debt-to-equity ratios vary greatly by industry and company, a general rule of thumb holds that a reasonable ratio should fall between 1:1 and 1:2. Some experts recommend that companies rely more heavily on equity financing during the early stages of their existence, because such businesses may find it difficult to service debt until they achieve reliable cash flow. However, start-up companies may have trouble attracting venture capital until they demonstrate strong profit potential. One advantage of debt funding is that interest payments are tax deductible, whereas payments to investors in C-corporations are not.
Hybrid securities are a broad group of securities that have characteristics of both debt and equity. These securities became popular in 2005 when the rating agency Moody's established a new set of guidelines that allowed institutions to classify securities on a debt-equity continuum. The previous policy had been to treat the entire amount as debt. Companies are attracted to hybrids because they tend to include enough equity-like features not to be classified as debt on the balance sheet, and have enough debt-like features to achieve tax-deductions and inexpensive capital.
In any case, all businesses require sufficient capital in order to succeed. The most prudent course of action is to obtain capital from a variety of sources, using both debt and equity, and hire professional accountants and attorneys to assist with financial decisions.
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Jefferson, Steve. “When Raising Funds, Start-Ups Face the Debt vs. Equity Question.” Pacific Business News, 3 August 2001.
Moose, John E. and Patrick M. Jones.“Is It Debt, or Is ItEquity?” American Bankruptcy Institute Journal March 2007. Available from: http://findarticles.com/p/articles/mi_qa5370/is_200703/ai_n21283870.
Tsuruoka, Doug. “When Financing a Small Business, Compare Options, Keep It Simple.” Investor's Business Daily, 3 May 2004.
WomanOwned.com. “Growing Your Business: Debt Financing vs. Equity Financing.” Available from: http://www.womanowned.com/Growing/Funding/Financing.aspx.