As a small business owner, Melba manufactures homemade all-natural fruit and vegetable punches and currently sells them to two health stores in her local community. Increased demand for her product has encouraged her to expand her business to ramp up distribution to include a popular supermarket chain. In order to do so, Melba requires capital to upgrade her kitchen, hire additional workers and purchase a new transport vehicle. She approaches her bank for a loan for the sum of money with an agreement to repay with interest over a fixed period of time. Her good friend Patsy learns of her aspirations and offers to give her the funds she requires in exchange for a 20% stake in her business, where she (Patsy) will receive 20% of the profits, once the business turns over a profit.
When raising capital to either start your own business or expand your existing operations, entrepreneurs are often faced with making a choice, between debt and equity financing just as Melba does in the scenario described above.
Debt and equity are two main modes of raising capital, each with its separate advantages and disadvantages. More commonly known, debt financing involves accessing a sum of money from lender which is to be repaid over time with interest. On the other hand equity financing involves accessing funds from outside investors in exchange for giving up a stake in your company. The choice between equity and debt affects you and your business in number of ways including the level of risk you assume and the control and decision making abilities you relinquish.
With equity financing investors assume the risk that their investment may not provide a return if the business isn’t profitable. If the company does not make a profit, nothing is owed to the investor. However with debt financing, in the form of a loan from a bank for example, monthly installments on the loan payment are required regardless of the financial health of the business. As such, a business owner should budget for these payments and ensure that he has the ability to repay the loan. There exists the risk of insolvency if the company has pledged assets of the company and is unable to service its debt.
Implications on Cash flow
Debt is a cost that soaks up cash flow, which is often and accurately, described as the life blood of a company. Fixed monthly installments reduce the availability of cash which could be used for critical payments in times of distress. The inability to manage cash flow has led to the decline of many businesses. Unlike debt, equity payments are not based on a fixed claim rather on a residual claim, once profits are achieved. One bonus of debt financing compared to equity financing is that interest payments are tax deductible. On the income statement this is explained as interest expense (accrued over the period covered by the financial statements). This has the effect of reducing the amount of tax paid, as the taxable income is reduced by the amount of the interest payment. The cost of equity is not tax deductible.
Impact on Decision Making:
On the downside, equity financing involves giving up part ownership of your company which may include some decision making power and control. Third party investors may demand input into how the business should be operated and sole decision making authority is removed from the single business owner. Compromises between the owner and investors may be necessary if there are differences in opinions with regards to key business decisions. Contrarily, lenders do not have any say in how the business is run nor do they have any input into decision making regarding the future of company.
The length of the period to repay debt is fixed and definite. For example a loan taken for a five year period will come to maturity after five years. Equity meanwhile has no deadline and will continue for the life of the business unless investors choose to sell their stake in the business.
Both types of financing come with their own pros and cons, it is up to the business owner or entrepreneur to decide which is best, taking into consideration his present circumstances, carefully weighing his options.