Debt vs. Equity Financing (Encyclopedia of Management)
Debt vs. equity financing is one of the most important decisions facing managers who need capital to fund their business operations. Debt and equity are the two main sources of capital available to businesses, and each offers both advantages and disadvantages. "Absolutely nothing is more important to a new business than raising capital," Steve Jefferson wrote in Pacific Business News (Jefferson, 2001). "But the way that money is raised can have an enormous impact on the success of a business."
Debt financing takes the form of loans that must be repaid over time, usually with interest. Businesses can borrow money over the short term (less than one year) or long term (more than one year). The main sources of debt financing are banks and government agencies, such as the Small Business Administration (SBA). Debt financing offers businesses a tax advantage, because the interest paid on loans is generally deductible. Borrowing also limits the business's future obligation of repayment of the loan, because the lender does not receive an ownership share in the business.
However, debt financing also has its disadvantages. New businesses sometimes find it difficult to make regular loan payments when they have irregular cash flow. In this way, debt financing can leave businesses vulnerable to economic downturns or interest rate hikes. Carrying too much debt is a problem because it increases the perceived risk associated with businesses, making them unattractive to investors and thus reducing their ability to raise additional capital in the future.
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.
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. But start-up companies may have trouble attracting venture capital until they demonstrate strong profit potential. 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.
CCH Tax and Accounting. "Financing Basics: Debt vs. Equity." CCH Business Owner's Toolkit. Available from <<a href="http://www.toolkit.cch.com/text/P10_2000.asp/" target="_blank">http://www.toolkit.cch.com/text/P10_2000.asp/>.
Jefferson, Steve. "When Raising Funds, Start-Ups Face the Debt vs. Equity Question." Pacific Business News, 3 August 2001.
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 <<a href="http://www.womanowned.com/growth/funding/financing.htm">http://www.womanowned.com/growth/funding/financing.htm>.