Archive for the ‘Debt vs Equity Financing’ Category
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The Oldest Business Funding Question – Debt Versus Equity
There is a constant debate over the use of the two main types of small business loans and which is more useful. In truth they both have their place, and rather than argue over the attributes of each, businesses are wise to use a combination of both at opportune times during their growth.
Small, or new business owners may not fully understand what the differences are, and some, new to the business financing realm may not even know what equity financing is. The term equity is bandied about in personal loans regarding the value of assets versus outstanding loan amounts placed on it, and equity is acquired much the same way in businesses. However, equity lending is not done on a personal level so understanding how the equity can be used to fund a business is something all newcomers should understand.
The Two Sides of a Coin
Debt Loans:
Debt lending is the side of business financing almost everyone is familiar with. It is a straightforward loan that works much the same for businesses as it does for personal loans. It is a set amount of money “mortgaged” on the business or is other variable assets set to play out over a period of time and charged an interest structure for repayment.
Debt lending has many qualities that make it an attractive form of business financing the first of which is the all important build up of credit for good performance in repayment. The downside of debt financing is that it requires repayment that can take away from a business’ profits, usually requires collateral in the form of business assets, or personal assets to secure the loan, and perhaps the most difficult aspect of debt financing of all: debt lenders are notoriously conservative. It is up to the business owner to prove the value of their company, their ability to repay a loan, and the financial prospects of their company.
Another positive value of a debt loan vs. an equity loan is that the interest paid on a debt loan is tax deductible. Perhaps an even bigger incentive to choose a debt loan is that debt loans offer lenders no control over the way the business is run.
Equity Loans:
Equity loans are far less understood by many business owners. These types of loans can be made by private investors as well as banks, and do not involve payment structures or interest because, hang on to your seats-you don’t have to pay them back! Whoa, before you go dancing off to your local finance institution to plunk down a request for equity financing here’s the catch: Equity financing is an exchange of financing in exchange for a piece of your company. You are selling off part of the value of your company.
This is basically like taking on a partner, although some financing is offered without actual control, you will be paying an equal amount of the profits of your future business profits to your new “partner.”
Whether equity financing comes with an active or silent partner many business owners are reluctant to sell off part of their future profits. Another downside is that since there are no “payments” as in debt financing there is nothing to deduct on your businesses tax filings.
Another aspect to take into consideration is that equity financing, often known as venture capital, is usually only offered if a business can prove it has the potential to use that money to create an explosive growth so that its performance escalates, thereby providing a great return on investment for the lender.
Which Type of Financing to Choose
Equity financing can be difficult to obtain in some situations. New businesses usually neither have the equity built up, nor the track record to judge a business’ performance to obtain such a loan. That however, is also the problem for new businesses when applying for a standard debt loan. Chances are, if you have a strong business plan, good concept, and any equity value at all in the form of inventory, building, or equipment you can find private investors that might be easier to obtain than bank debt financing.
Equity finance companies are also more competitive and aggressive. They can take more chances because the potential for payoffs are greater. With debt financing the return on investment is a set figure-no less, no more than the original contract. With equity financing if the business really takes off the financer stands to reap great rewards.
One argument is that debt financing, if at all available, offers business owners the most security, less potential loss over time, and no loss of control over company direction or operation. It would seem that it is the best choice in all situations, and yet businesses big and small who understand both forms of financing well know that there are times when equity financing simply makes more sense.
If you do not have enough profit to repay a debt loan, equity financing makes good sense. It can offer you the means to expand or implement new procedures to maximize your income potential where you can then apply for a more standard type of loan. Startups with a dynamic business plan have the most to gain from equity financing. They very often cannot afford to repay a debt loan, but will in the foreseeable future have massive profits.
Established businesses that find themselves stagnated and in need of a boost of cash to expand may not be in a position to pay monthly payments on a debt loan either. They may also find banks even more reluctant to lend money on the chance they will improve than they are willing to finance a startup. In those cases an equity loan works excellently.
Once a company, regardless of its duration is capable of acquiring and maintaining payments on a debt loan it should seek that type of financing. Even venture capital lenders will shrink away from a company that never grows to the point where it can afford to take on a debt loan. Companies that are ever expanding and always on the edge of fiscal stability will look like risks to either side of the coin so it is important to have lengthy periods of time where the business is operating in a healthy profit margin before attempting to get further loans of either type.
Each individual businessman will have their own ideas of the perfect combination of debt and equity financing. Businesses using both to their maximum benefits are well on their way to a solid future. Instead of thinking about the issue as debt VS. equity financing, business owners should think of it as debt AND equity financing for a secure future.
Corey Pierce is the CEO of BusinessFinance.com that since 1995 has been one of the internet’s largest resources for business owners in search of business loans. BusinessFinance.com has developed a business funding system that matches a businesses owner’s need for capital to the approval requirements of over 4,000 business lenders. Find out more about getting your business loan approved at: => http://www.businessfinance.com/
Debt Versus Equity Financing FAQ:
Question: What are the advantages of using equity versus debt to capitalize a firm?
Answer: Investors will be more attracted to the possible growth of a firm and dividends they will collect as opposed to fixed income. There’s more growth potential with shares than with bonds.
Question: What would the advantages and disadvantages of raising capital via debt (bonds) versus equity (stock)?
Instead of borrowing cash to pay for its investments, a firm can sell new shares of common stock to investors. Whereas bond issues commit the firm to make a series of specified interest payments to the lenders, stock issues are more like taking on new partners. The stockholders all share in the fortunes of the firm according to the number of shares they hold.Answer: It’s usually a question of not either or but rather a question of the optimal mix of debt vs equity. A company’s optimal capital structure is a fairly complex analysis but in general a company analyzes the risk and reward between debt vs. equity with the goal of maximizing the company’s stock price. Every company establishes a target capital structure (% of debt vs. % of equity) which may change over time based on the company’s current capital structure, future expected capital raising needs, tax position, expected need for financial flexibility etc. Generally, when a company’s debt ratio is below the predetermined optimal target % companies typically raise new capital by issuing debt…when the debt ratio is above their optimal target % they typically raise capital by issuing equity. The advantages of issuing debt are primarily that the interest is tax deductible which lowers the effective cost of the debt and stockholders don’t have to share the profits of the business with debt holders. The main disadvantages are when a company’s debt ratio increases to the point where the associated risk makes future borrowing too expensive and therefore reduces a firms capital flexibility…it can also lead to bankruptcy due to the fixed cost of servicing the debt in an otherwise healthy company.
Question: Should a company have more debt or more equity in its capital structure? What are some limitations of utilizing debt versus equity in the capital structure?
Answer: Excessive debt financing may impair your credit rating and your ability to raise more money in the future. If you have too much debt, your business may be considered overextended and risky and an unsafe investment. In addition, you may be unable to weather unanticipated business downturns, credit shortages, or an interest rate increase if your loan’s interest rate floats.
Conversely, too much equity financing can indicate that you are not making the most productive use of your capital; the capital is not being used advantageously as leverage for obtaining cash. Too little equity may suggest the owners are not committed to their own business.
Question: What is an advantage of equity financing over debt financing?
Answer: It’s possible to raise more money than a loan can usually provide.
Question: Why is debt financing said to include a tax shield for the company?
Answer: People who advocate borrowing money for the “tax advantages” are bad at math. Pay $1 (in interest) to save $.28 (in taxes) STILL leaves you a net negative amount.
Question: What were the advantages of debt financing in the early 1990’s?
Answer: Fairly low interest rates. Debt financing was cheaper than the cost of capital. Basically, it was cheaper to borrow money than to give an investor an ownership stake in your profits.
Question: How tax advantage is available in case of debt financing?
Answer: The advantage is if interest expenses can be deducted from income, resulting in a lower cost of money borrowed.
Question: Will personal credit debt affect financing of my company?
Answer: The personal credit debt will effect financing of a company if you are a partner/owner of that company. The owners of smaller to medium sized companies may be effected.
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Commercial Finance – Debt Vs Equity Financing
Financing is financing, right? A loan for a business is just like a loan for a home, right? Unfortunately, this simply isn’t the case. Commercial financing is an entirely different game compared to personal financing.
Sooner or later, you are going to need financing as a business. It might be to get up and started. It might be to finance materials needed to fulfill a large order. Whatever the reason, it is vital to understand that there are two basic forms of commercial finance for businesses – debt financing and equity financing.
Equity financing is the most common choice of newer businesses. Why? Well, the statistics are fairly ugly. Something between 70 and 90 percent of all new business fail within two calendar years from the date of launch. As a result, traditional commercial banks are loath to invest in newer companies. The risk is just to big that a default will occur.
So, what exactly is financing and who does it? Well, equity financing is not really financing at all. It is the sale of pieces of ownership in the business to drum up money. For most small businesses, this means tapping into the bank of Mom & Dad as well as lightly twisting the arms of friends. For businesses with bigger ideas, angel investors or venture capitalists can also be sources of funding. The primary issue to keep in mind, however, is once that equity is sold off, the business is no longer “yours”. It is owned by a group and a group that wants to make a profit.
Debt financing for a business is much more like personal financing. You are usually dealing with a bank. Assuming your company has been around for a bit, the bank will be receptive to chatting with you about your financing needs. That being said, it is not going to give you a general loan. Commercial debt financing usually is tailored to a specific need. If my business needs to buy a piece of equipment, the lender will give me a loan for that specific piece of equipment.
There is one area where commercial banks will provide more general financing to small businesses. This is in the form of a line of credit. These lines can be a blessing and a course. First, they are expensive. Second, they tend to be watched closely by the bank. You might have a million dollar credit line, but you will rarely get to use it all. If the bank sees your balance going up towards the limit, it will often call the line. This means it will essentially demand payment within a specified time. If you do not make it, the bank will come after your assets since it required you to personally guarantee the line. This is something you see happen with service companies, such as law firms, all of the time.
So, which form of financing is better for your business? If you can swing it, debt financing is by far the best. Giving up ownership interests in your company should be avoided, which makes equity financing a Faustian bargain.
Stephen Teak writes about financing through commercial loans for small and big businesses alike. Read more of his work at CommercialLoanStop.com.
Debt & Equity Financing FAQ:
Question: Equity vs Debt Financing. For a large business which is preferable?
Answer: That really depends. Debt financing requires getting an outside loan, and the company must pay it back plus interest. Equity financing requires using some of the company (or owner) ownership to someone else, which means that the company will have yet another person with different ideas who has ownership in the company. On the plus side, equity financing doesn’t require putting up any assets.
Large businesses are probably going to want to use equity financing, such as issuing stocks, which many already do.
Question: Equity versus debt financing of a foreign subsidiary?
Answer: Both alternatives depend on the foreign country that is the subsidiary’s market. If you choose borrowing, the interest rate prevailing there would be very critical (as measured against the-higher-the-better inflation rate); so would be the exchange rate and a lot of other country risk measures. You must not borrow in excess of the borrowing capacity of your subsidiary. The last thing you want is excessively high interest burden especially if too much cyclicallity is inherent in this foreign country or the industry your subsidiary pursues. The equity alternative can be less appealing because of the typically higher required return but still higher equity serves as a buffer against losses and conveys less interest burden. All in all you need to analyze both your subsidiary’s business and market very carefully to assess the tradeoff.
Question: Compare Debt vs. Equity Financing for a business.
Answer: Debt financing means borrowing money that is to be repaid over a period of time, usually with interest. Debt financing can be either short-term (full repayment due in less than one year) or long-term (repayment due over more than one year). The lender does not gain an ownership interest in your business and your obligations are limited to repaying the loan. In smaller businesses, personal guarantees are likely to be required on most debt instruments; commercial debt financing thereby becomes synonymous with personal debt financing.
Equity financing describes an exchange of money for a share of business ownership. This form of financing allows you to obtain funds without incurring debt; in other words, without having to repay a specific amount of money at any particular time. The major disadvantage to equity financing is the dilution of your ownership interests and the possible loss of control that may accompany a sharing of ownership with additional investors.
Question: What is the difference between debt and equity finance, and what exactly is structured?
Answer: When a company needs money it can take on debt, eg borrow money from a bank which then has to be repaid.
Or it can issue more equity, (i.e. shares) and this is equity finance. It does not require repayment.
A structured loan is one having a definite structure, eg 60% loan and 40% equity, the loan payable in equal amounts over 3 years.Question: What is the risk involved in other financing situations such as selling bonds, issuing stock, venture capital, debt, and equity financing?
Answer: The risk in selling bonds is if you default on the bonds you will have to file for bankruptcy liquidate your assets in order to pay your creditors before you are able to recoup anything for your business. Creditors have first crack at liquidated assets.
The risk in issuing stock is the diminished ownership in your venture and the requirement to please shareholders and depending on your company this may get tedious.
Venture capitalists often demand exorbitant returns on their money, often 200-300% over a short term period (3 years). So you can see all your profits go directly to a venture capitalist.
Debt financing is a different way to say selling bonds and equity financing is a different way to say issuing stock.
One other option is to find an angel investor, someone willing to offer in most cases a smaller contribution than a venture capitalist but often an unfettered contribution. Look for philanthropist types who are interested in seeing small businesses succeed, or family members.
Question: Financing fixed assets using debt funds is beneficial for a company or through equity funds?
Being a financial consultant of a company what will be my advice as to how to finance their fixed assets…either by using equity funds or by using debt funds?Answer: That would depend on the rates of debt and equity. Both of these methods have equations, and you select the balance that you feel gives the minimum amount of risk and maximum return (this is called capital structure).
Generally, debt is cheaper.
Question: What is the proportion of debt financing for a firm that expects a 24% return on equity, a 16% return on asset?
Taxes to be ignored.Answer: You need more information than that. If you’re trying to derive a proportion of debt, you need the WACC, the cost of equity, and the cost of the debt to determine the weights.
WACC = Weight of equity * cost of equity + weight of debt * cost of debt.
Once you have the cost of debt, you can solve since you know the weights have to add to 100%, there’s only 1 variable left.
Question: How does the federal income tax structure impact a businesses decision to finance with use of debt vs. equity?
Answer: If you’re using a leveraging formula, you need to take the tax rate into account along with the interest on the debt in order to have return on assets as well as return on equity. The impact is that interest on your profits are taxable, while the interest on your debt is deductible. (Corporations using capital budgeting will usually use a 35% tax rate, their highest.)
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The Difference Between Debt And Equity Financing
There are two main types of financing for a business, debt or equity financing. Debt financing tends to be the type of financing you receive from a traditional bank loan and equity financing tends to be financing you receive from venture capital into your business from outside investors. The benefit of debt financing is that it is finite and you will pay down the debt over time to a zero sum balance without any further obligation to the lender. The down stroke to debt financing is that traditional lenders will take a hard look at your business including how long it has been in existence, income from operation, expenses and will require hard assets for collateral for the loan. Additionally, lenders will most certainly want you (and any other principals of the organization) to personally guarantee repayments of the loan. Another disadvantage of debt financing is that your organization will be burdened with some other type of regular payment (usually a monthly payment) depending on the terms and conditions of the financing and this can absorb critical cash flow, especially with small business.
The benefit of equity financing or venture capital is that you will be receiving money in exchange for equity in your business in the form of stock or some other form of equity like percentage of income or gross/net sales. A primary benefit of this type of financing is that typically there is no monthly payment requirement to investors. Instead, you are giving up ownership interest, most often, permanently.
Traditional lenders, banks for example, will look at your business much differently than venture capitalist. Bankers want a zero-risk or near-zero risk position when they provide financing and will rely almost completely on the operating economics of the business with little regard for “potential future growth”. They want to see strong cash flow backed up by hard assets before they do a deal—the ingredients that most small business lack or they wouldn’t be seeking financing, right? Venture capitalist, on the other hand, tend to consider the management team and the potential future growth of the business more heavily than actual operating numbers, especially for small business with large potential but few sales and little or no operating history. Although these two lender types vary in their approach to analyzing a business for funding, you can be sure that careful scrutiny of you business will be conducted.
Besides the actual operating economics and pro forma analysis, both types of lenders will look closely at two particular documents: 1. Your business plan. 2. Your bank or loan request package. These two documents, if assembled correctly, can make the difference between success and failure when dealing with either lender type.
There are plenty of free SBA related materials that tell you how to create blue-chip, boiler plate business plans but they tend to be written for perfect businesses and not the average Joe who is less than picture perfect. If you are seeking some type of financing for your business I strongly suggest that you visit our site and check out our business e-books. We have several that cover a variety of topics and there are specifically two that will be a real treasure for you to own. One is called Power Planning (a powerful report on writing a wide variety of business plans) and How To Raise Money For You Business (teaches you how to assemble professional loan requests packages). They are priced at $5 each and can be worth millions in the hands of the right person. I am not trying to hype product, I am simply giving you a heads up.
The secrets to getting financing from either type of lender is a closely held secret by financial and business brokers for a number of reasons. Chief among them is it forces people like you to do business with them and they earn commissions. The SBA materials, while good, do not have the street savvy to get the job done in most cases. The proof is in the pudding—what has the SBA ever done for you? The SBA is just another government back bureaucratic nightmare for most. We also have some links for venture capital firms in our business links area located on our site on the Smart Link Zone page—it’s all-free.
Give it some thought…. Your future may depend on it.
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Debt & Equity Financing FAQ:
Question: What might be an appropriate middle ground between debt and equity financing?
Debt financing is more risky than equity financing, but equity financing is more expensive.Answer: It really depends on what you’re looking for and how much you need. I don’t know if I definitely agree that debt financing is more risky and equity more expensive. In a start up situation, it really depends on the entrepreneur–what kind of credit background do you have, how much capital do you have, what is the market potential, etc.
Usually, an appropriate middle ground is a balance between the two. Obviously, in a high risk situation like a start up, the risk inherent to debt exists mostly when the borrower must use his or her home or possessions as collateral. If that’s the case, it’s probably better to go solely with equity. If the venture is less risky, say for example a franchise, then borrowing is also less risky, and therefore probably better. In either case, you’ll want to borrow from whomever you can get the most favorable terms–usually family, friends, and fools, if they can put up the money–and get equity from the people with the most experience and contacts since equity investors will take a direct role in the company. You should chose equity partners not only for the money, but more importantly for the experience and contacts they add.
Question: What are the advantage and disadvantage of debt financing and equity financing?
My company has been talking to a consultant and I need to know what the advantages and disadvantages are before I make any moves!Answer: Here are some considerations:
Debt Financing – Advantages: interest payments are tax deductible, there is no dilution (decrease in ownership) to existing equity holders. Disadvantages: the debt holder has FIRST CALL on all assets of the Company (in advance of equity holders) in case of a liquidation. Also, there are many covenants associated with debt instruments that may impact a company’s freedom of action. Of course, debt instruments usually have current payments required – which means if you don’t have current net operating income this can cause difficulties.
Equity Financing – Advantages: No current payments due; No preferential rights on assets of the Company. Disadvantages: Dilutes ownership of current equity holders; may result in control loss issues.
Of course, this presumes you use COMMON equity financing – if a Preferred Equity structure is used it can often mimic some of the characteristics of debt financing without the advantage of tax deductibility.
Question: What’s the difference between equity financing and debt financing?
Answer: Debt financing means you’re borrowing money and will pay it back (with interest). This can be through a loan, or bonds, or other types of debt.
Equity financing means you’re selling a part of your company in exchange for capital. This could be through partnership, stock, etc.
Question: Is there a difference in using debt financing or equity financing on shareholder value?
Answer: Equity financing is dilutive to existing shareholders. Excessive debt financing can ruin the balance sheet and lead to cash crunches.
Question: Compare and contrast long term debt and equity financing?
Answer: Long term debt is riskier at start up as there will be a definite cost through interest payments while equity is selling part of the business so you won’t have the same costs of interest. In the long run however, if the business is successful then debt would end up being a cheaper way to finance as a successful company will have its shares rise in value so your opportunity to get the full amount of this gain would be lowered by what you sold. Equity financing also has the added benefit of more owners who may have specialized knowledge and skills and would be willing to provide that skill as they hope for the business to be a success.
Question: What factors associated with debt vs. equity financing might influence price-earnings multiples?
Answer: It deals with the capital structure of the company. As the company has more debt and less equity, it’s more highly levered and thus more risky, leading to a higher P/E. With more stock than equity, there’s less risk, which would probably trade at a lower P/E.
Question: Explain why there is a tradeoff between debt and equity financing?
Answer: There is only a certain amount of money you need for a particular project. Usually the only money you can get is debt financing and equity financing, so if you get more equity financing, you don’t need so much debt financing, and vice versa.
Question: Would a company financing with debt or equity have a greater tax shield effect?
Answer: Financing with debt provides interest tax shield as interest expense is tax deductible, whereas if financing is done by equity, the dividends distributed are not tax deductible.