Debt and equity financing is important because any business, big, small, or startup can end up needing extra capital. Capital is what makes a business run. A constant flow of capital in and out of your business is what makes it all work.
For your business to be successful you need more coming in than going out. Generally, it is all very simple, but if you’ve owned or operated a business you know the challenges and opportunities are in the details.
Most successful businesses understand how to leverage and get the most from equity and debt financing. Having a solid understanding of the difference between debt and equity financing, and how and when to use each can shoot you past your competition and set you on the road to financial success and stability.
Debt and equity
Before going any further, let’s define these two key terms to make sure we are on the same page.
Let’s first talk about debt, most everyone is familiar with personal debt. When we talk about the business debt it is not conceptually different, just different in respect to types of loans, responsibility for repayment, and ways that funds can be used.
The main difference between business and personal debt is who is actually responsible for the repayment of loans. If the business is on solid footing financially it is very likely that you can get a loan and only the business is responsible for paying off the debt. This removes you, the owner, from personal responsibility.
A business considering debt financing has a number of options.
Each of these options has its pros and cons and the best situation where it will have a better return than the other types.
Equity
Almost all businesses have used equity financing. It is actually the most common type of funding for a business. If the owner, the owner’s friends, or family have put money into the business then that business is funded by equity capital.
Equity represents the shareholders’ stake in the company, identified on a company’s balance sheet. Investopedia
There are generally 4 types of equity investment:
- Investor
- venture capital
- Angel
- Owner
- Friends, family
- Crowdfunding
7 things you should know about debt equity financing
1. Debt can have unexpected costs in funding
Multiple closing costs: These are fees charged to service the loan. And can include loan-packaging fees, appraisals, and a business valuation.
An origination fee: This is a fee that a lender will charge to process a loan.
Underwriting fee: An underwriter will charge a fee to review and verify the documents that have been provided. This includes financial statements, personal bank statements, credit reports, and tax returns.
Loan guarantee fee: If you are using the SBA they will charge a guarantee fee of 0.25% to 3.75%, based on the size of the loan. This fee is a direct charge to the lender to ensure the loan, but the lender may pass this on to you.
2. The unexpected cost of equity funding is;
The definition of cost of equity is the financial returns investors who invest in the company expect to see.
Unexpected costs can come from your investor’s expected rate of return. You may be required to share profits at end of year.
Part of the deal with equity investment is the investor now owns a portion of your business and your agendas can end up being different. So if your business grows rapidly your investors will have a larger claim on future earnings on a dollar per dollar basis.
3. The difference between debt and equity financing can impact your business in significant ways.
Equity financing requires that you trade ownership for capital. Depending on the agreement to get that capital your new partners can make significant unwanted changes in how your business will operate. Examples may include a refusal to add more debt, a focus on cost-cutting over marketing.
The main difference between Debt and equity funding is debt requires regular payments. Equity does not require these payments. These debt payments will affect your cash flow. This effect could be positive or negative depending on the structure of the loan and what it was used for.
The right debt financing can improve cash flow.
Getting the right terms on a loan can actually improve cash flow. There are several sources of debt funding that businesses can access. Each type has requirements that translate to costs. Matching up your needs to the right loan will minimize the cost and maximize the return.
A key determinant to determine the type of financing is will the asset pay itself off by the end of its useful life and does it generate a positive return during the payback period.
Equity financing can have significant advantages for your business
Advantages of choosing equity financing are no regular payments, the ability to use the funds in flexible ways to get the best returns. Getting business advice and assistance from your investors. Improved relationships and networking opportunities.
Use of Equity financing can cause you to lose control of your company.
There is no shortage of examples of a business that is growing rapidly that is taken over by investors. When someone invests in your company they expect a return. If that does not happen they feel and have the right to do something about it. How much say they have is determined by the arrangement you’ve made to get the funding. If your contract does not protect you, your investors can turn on you and remove you.
A poor debt-equity ratio can prevent you from getting funding
The debt to equity ratio is just what it sounds like how much debt does a company has compared to how much equity. It is a measure of the degree to which a company is financing its operations through debt versus wholly-owned funds.
When the ratio is too high for debt, in other words, more debt than equity or getting close to that, most lenders will stop lending as the risk of default is growing.
Business Examples
Equity example
Famous Amos is an interesting story of how equity financing was used to save the company but ended up ousting the founder. Famous Amos is a cookie company that in 1982 had revenues of 12 million. The company was founded with help from celebrity investors and as it grew the owner continued to look for equity financing.
Poor management decisions and market changes caught up to the business and revenue began to drop off a cliff. Mr Amos the founder and owner continued to access equity financing. Because the company looked risker, the terms for equity became more and more onerous. Many of these investors were looking for quick payback and when they did not see that happening they forced the sale of the company. Mr Amos lost his company and the use of his name. This story does have a happy ending, Kibbler Co. eventually bought the rights and hired Mr. Amos back to be the spokesperson and gave him back the rights to his name.
Success stories are plentiful, one of the most popular is Facebook. Peter Thiel, was Facebook’s first big investor, in 2012 he sold off most of his stake, turning his initial $500,000 investment into more than $1 billion in cash. And that is why investors are willing to risk funds for huge potential returns. And of course Zukerberg the founder is still in control.
Debt example
Boeing is a good example of how debt can gain control of your company and push you towards bankruptcy. Boeing currently carries eight times or much more in total debt versus annual adjusted cashflow. What happened? The 737 max disaster, and coronavirus. Two extreme market factors pushed Boeing from operating profitably to looking at restructuring. The business model for Boeing required massive amounts of debt to be able to operate the business, but this also put the company at risk when the market or unexpected events turned against them.
Boeing is also an example of the successful use of debt financing to grow their business. Historically Boeing has used debt very successfully to grow the business as a whole. By all indications, Boeing will weather this latest storm and continue on its growth trajectory. They have many challenges but because of long-term relationships, they will restructure debt and get back to profitability.
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