Debt vs Equity Financing – What are the advantages and disadvantages?
A company can choose to source new capital by issuing equity or debt. A company needs to consider the advantages and disadvantages of each type of capital before they make a decision. These are considerations that a company would have to process before determining which financing option makes the most sense for their situation. The visual below summarizes the key advantages and disadvantages for each option:
Equity Financing – Advantages and Disadvantages:
Advantages of equity financing include the following:
- Less risky than debt: There is no guarantee that the company must repay investors if the company goes bankrupt.
- No future obligations: There is not a future obligation to repay the capital to investors like there is if the company utilizes debt financing.
- Gain investor network: A company should look for investors that offer strategic benefits to the company (i.e., industry knowledge, partnerships, etc.).
- No fixed timeline: Unlike debt financing, there is no fixed timeline that a company must follow with equity financing.
Disadvantages of equity financing include the following:
- Shared decision making: Since investors are now owners of the company, they will have certain decision-making power. Voting rights will vary by investor depending on what class of stock they own.
- Potentially costs more: This one is a bit subjective, but if the company becomes very valuable, then the equity given up could be significantly more costly had the company chosen to raise the money through debt financing.
- Investor pressure: Investors typically pressure a company more to expedite timelines and returns. With debt financing, lenders are typically only concerned with the company’s ability to make their required payments.
Debt Financing – Advantages and Disadvantages:
Advantages of debt financing include the following:
- Retain ownership: With debt financing, the lender or creditor does not receive any shares or ownership of the company. With equity financing, the company sells ownership to investors.
- Interest is tax deductible: Interest expense can be used by a company to reduce their taxable income. This is not the case with equity financing.
- No future obligations: As soon as the company repays the loan, there is no future obligation to the lender or bank. This is not the case with equity financing as the investors are part of the company for the indefinite future.
- Variety of terms/rates: There are many different types of loans a company can obtain. Each of these loan types will have different repayment terms (short or longer) and interest rates. Lenders compete to offer borrowers the best rates.
Disadvantages of debt financing include the following:
- Must repay in future: Loans must be repaid one way or another. Either the company has to repay or usually the owners will have to repay with personal funds.
- Usually requires collateral: Depending the credit rating of the company and its owners, the lender may require collateral (equipment or land) or personal guarantees by the owners.
- Impacts cash flows: The company will have to make periodic interest and principal payments according to the loan schedule. This is a real cash outflow that the company has to pay, typically with cash from normal operations.
There are obviously a lot of different things to consider when choosing how the company will source capital. For some companies, debt financing may not even be an option as banks and lenders typically have strict lending requirements. If a company cannot obtain debt financing, they would be forced to turn to equity financing.
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