Usually, there are two general options available to corporate entities when faced with capital raising. They can either raise money through Equity or Debt financing. Often, there are questions concerning which is the most preferred amongst the two. This article seeks to provide a bird’s eye view on the two major financing options.
Equity financing refers to the sale of a company’s shares to either new or existing investors to raise the company’s funds. A company can obtain equity funding from investment banks, private equity firms, venture capitalists, large cooperatives, individuals, etc.
Advantages of Equity Financing: Primarily, amongst so many other advantages,
• There is no obligation on the company to repay the money received.
• There is no additional financial burden on the company.
• Since there is no required weekly/monthly payment of interests, the company would have more funds at its disposal.
Disadvantages of Equity Financing: Primarily, amongst so many other disadvantages,
• Ownership of the company is shared with a third party/Investor, who as a shareholder will have rights to information and access to the Company’s books, which will result in scheduled reporting, which can be quarterly or biannually.
• The company must share its profits with the investor, now Shareholder whenever it declares dividends.
Debt financing refers to borrowing funds from a lender to repay with cash or in-kind as interests over a defined period. Debt financing can be a funding source for working capital or long-term investments. The most common form of Debt financing is a loan. Others include overdrafts, fixed income debt securities, finance secured on assets, etc. Sometimes, a term in a debt financing agreement can seek to limit the type of business a company engages in, which may prevent the company from taking up opportunities as they come.
Advantages of Debt Financing.
• Debt financing does not involve surrendering any part of ownership/stake in the business.
• The relationship between the parties is effectively defined, and it comes to an end once the loan is repaid.
• The company retains control during the loan term.
• Interests paid are tax deductible.
• The rates do not fluctuate, and as a result, the company is never in doubt of how much it is obligated to pay.
• If the company pays back the loan in time, it will add to its creditworthiness.
Disadvantages of Debt Financing.
• The loan must be repaid even if the business is not profitable after investing the loan sum.
• The process of obtaining Debt Financing can be lengthy and time-consuming.
• Creditors require collateral, i.e. security. When the company cannot repay the loan, the lender will use the collateral to recover the loaned sum.
When can your company use Equity Financing or Debt Financing?
Equity Financing is most suitable for businesses in the early stages, are not yet profitable, have no financial history or collateral to use as security, or have a short-term need for cash. Equity Financing allows the entrepreneurs to focus more on the business rather than be burdened with repayment of principal/interest. However, there is a high risk of losing ownership and control of the company. For the investor, he/she/it will only gain profit when the business declares profit.
On the other hand, debt financing is most appropriate for established businesses. However, the lender will consider the company’s creditworthiness and good financial history.
Compared to equity financing, debt financing is less expensive and can be customized to satisfy the individual business’s needs. Debt Financing will not be suitable for seasonal companies or enterprises with erratic cash flows.
In conclusion, there is no one size fits all while considering an appropriate financing method. However, questions like how much money the company needs, what the funding is required for, availability of collateral, and if the additional input of a new investor is required, if answered appropriately, will aid in determining the best financing option.
By Whitney Agbo
Disclaimer: Please note that the critical items highlighted above are solely for academic purposes and should not be taken as legal counsel. For further information, kindly send an email to w.agbo@zuriel.com.ng, or info@zuriel.com.ng or contact our office, Zuriel Law Practice , 14a Dasilva Street, Off Ayo Jagun Street, Lekki Phase 1, Lagos.
References
- https://www.investopedia.com/ask/answers/042215/what-are-benefits-company-using-equity-financing-vs-debt-financing.asp#:~:text=Debt%20financing%20involves%20the%20borrowing,the%20money%20acquired%20through%20it
- https://aofund.org/resource/debt-vs-equity financing/#:~:text=Debt%20financing%20means%20you’re,for%20some%20percentage%20of%20ownership.
- https://smallbusiness.chron.com/advantages-disadvantages-debt-equity-financing-55504.html
- https://www.lightspeedhq.com/blog/advantages-of-debt-financing/
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