Companies can use either debt financing or equity financing to fund their financial needs. Normally, the cost of equity is lower than the cost of debt financing. However, if a company has a significantly larger equity portion without debt, its total cost of capital will go higher. Similarly, if a company has a too high debt ratio, its cost of capital will also rise.
Businesses can enjoy different advantages of both types of financing. However, it’s wise to seek an optimal balance between the two to keep the total cost of capital in check.
Definitions
Debt Financing is borrowing money in return for the premium paid on the borrowed amount. The premium is paid in the form of interest payments. It can take several forms to repay the interest and principal, depending on the type of borrowings. The lenders do not enjoy an ownership stake with lending money.
Equity Financing is exchanging ownership stakes against the investment. The borrowing company does not need to repay the money. The return for investors comes through dividends or capital gains in their stakes in the company. The borrowing company has to sacrifice a portion of ownership with lenders here.
How Does Debt Financing Work?
Debt financing can be obtained from commercial banks, private creditors, or crowdfunding sources. It can take a short-term or long-term form depending on the type of borrowing.
Creditors appraise the applicant’s credit profile to approve the borrowing request. The cost of debt depends largely on the nature of the loan and the creditworthiness of the borrower. A secured loan backed by collateral will incur lower interest costs than an unsecured loan without collateral.
Debt financing costs also depend on the credit history and leverage position of the borrower. A company with bad credit and a higher leverage ratio will face stern conditions from the creditors. Also, the cost of debt will increase in such cases.
How Does Equity Financing Work?
Private companies can raise funds through equity financing as well. Startups use the option by borrowing money from a venture capitalist or crowdfunding platforms. These creditors seek an ownership stake in return for their investments.
Public companies can raise capital through issuing shares in the stock market, known as IPO. A rights issue is also a form of equity financing where shares are offered to existing shareholders.
The cost of equity is higher for the fact that investors cannot redeem their investment in the case of borrower’s default. Also, if a company goes bankrupt the shareholders are last in the line. Hence, investors seek higher returns with equity financing as compensation for higher risks.
Debt Financing Vs Equity Financing – Key Differences
Debt financing does not require the borrower to share the ownership stakes. But they need to offer satisfactory creditworthiness to obtain the facility. The cost of debt is a tax-deductible expense. Hence, it is a favored option for the borrowers.
Equity financing does not need to be repaid as debt financing. However, the borrower will need to sacrifice the shareholding stakes. Investors would also seek active participation in the management roles often. For higher risks, the cost of equity is always higher.
Let us compare some key differences in both types of financing options.
Availability
Both options are available for all types of companies. Equity through IPO is an expensive and regulated process that small companies can ill-afford.
Debt financing can be obtained by showcasing a good credit history. Sometimes, lenders would want additional security in the form of collateral.
Cost
Under normal circumstances, the cost of equity is higher than the cost of debt financing. Risk factor plays the crucial role in determining the cost of capital.
Duration
Equity financing does not need to be repaid. Shareholders can sell their stakes if they wish to redeem their investment.
Debt Financing can be obtained flexibly for short-term and long-term periods.
Types
Equity Financing comes in the form of ordinary stocks, shares, preferred shares, and in some cases convertible debt.
Debt financing comes in the form of bank loans, bonds, debentures, commercial papers, P2P loans, personal loans, line of credit, government loans, and lease options.
Risks for the Borrowers
In equity financing, the borrowers do not need to repay the investment. Investors become shareholders; hence they face the same risks of default as the borrower. For that reason, investors seek a higher rate of return.
In debt financing, borrowers need to repay the loan, no matter what. If they fail, they can face litigation as well as the seizure of underlying assets.
Risks for the Creditors
Equity financers face the same risks of default as the borrowers. As they become shareholders of the company. However, they fall last in the line if the company goes bankrupt.
Lenders in debt financing may face the risk of default. In the case of secured loans, lenders can claim the pledged assets as collateral. They have the right to lien.
Returns for Creditors
The cost of capital in each type of financing is the return for creditors. Typically, the cost of equity is always higher than the cost of debt. For the fact that shareholders take higher risks. Debt financing needs to be secured in some form and must be repaid to the creditors, hence is less risky.
