Debt Financing Vs. Share Financing
Original post by Cam Merritt of Demand Media
When a business needs capital beyond what comes in from operations, it may get that money one of two ways: It may borrow money, called debt financing, or it may sell shares in the company to investors. Debt financing and share financing --- more commonly called equity financing --- each have advantages and disadvantages, and successful companies often use both approaches.
The prime advantage of financing a business through the sale of shares is that the money it brings in never has to be repaid. That doesn't mean investors don't expect something back. They certainly do, and that leads to the key disadvantage of equity financing: The "shares" being sold are shares of ownership. Those investors become owners of the company, and they're going to demand a return on their investment. If they don't like the way the company's being run, they'll push for change. This is how company founders can end up losing control of businesses they've built.
A company may obtain debt financing in multiple ways, from taking out a simple business loan through a bank to selling bonds to investors. However it obtains the money, the company must repay it all, with interest. That's obviously the primary downside to debt financing. On the upside, as long as the company meets its repayment obligations, the lender has no say in how that business operates. The owners retain undiluted control.
A company's ability to obtain share financing is limited to the demand for its shares. A struggling restaurant owner in need of money might love to sell 15 percent of the business to raise capital, but good luck finding an investor to buy in. On a larger scale, if a corporation's stock is already suffering the effects of low demand, such as a sagging share price, tossing another 1 million shares onto the market could be disastrous. In such cases, debt financing might be the only option. On the other hand, the ability to obtain debt financing is limited by the lender's willingness to extend credit. Each successive round of debt financing becomes more expensive. Think of an individual's finances: A person with a lot of existing debt is going to pay a higher interest rate on his next loan because he poses a bigger risk of default. It's the same with businesses.
Equity financing means having investors looking over the shoulders of management, but that's not necessarily a bad thing. Pressure to realize a return on investment may force a company to be "smarter" and more efficient. Particularly when a company is in start-up mode ---- when it sells shares on an individual basis to venture capitalists and others rather than to the general public --- bringing in equity investors means bringing in experience and insight that can strengthen the company. While debt financing means paying interest, but that's not necessarily bad, either. First, the interest is generally tax deductible. In addition, if a company uses the money it obtains from debt financing to produce a return greater than the interest, the loan becomes a moneymaker. Say a company borrows $10 million for five years at 7.0 percent interest. The company will pay roughly $1.9 million in interest over the life of the loan. If it uses the loan to build a factory that increases its revenue by $500,000 a year, it could recoup those interest costs before repaying the loan.
- "Financial Accounting for MBAs"; Peter Easton et al; 2010
- Entepreneur; Choosing Between Debt and Equity Financing; Asheesh Advani; April 3, 2006
About the Author
Cam Merritt has been a professional writer and editor since 1992, specializing in articles about spectator sports, personal finance and law. He has produced content for "USA Today," "The Des Moines Register" and the "Better Homes and Gardens" family of magazines and websites. Merritt has a Bachelor of Arts in journalism from Drake University.