Whether starting a business or growing a business, owners rely on capital to provide for needed resources. Debt and equity financing provide two different methods for raising capital. The key differences between debt and equity financing may help in determining which method will most benefit a company’s particular needs and goals.
Debt and equity financing provide a means for companies to carry out plans that require large amounts of money, such as developing new product lines, acquiring another company or starting a business. The two methods differ in terms of whether a company borrows the money or raises the money. Debt financing involves borrowing money from investors or lenders, while equity financing requires a company to sell a percentage of its interests to investors.
When considering debt vs. equity financing, a key difference between the two has to do with who gets or maintains ownership of the company. With debt financing, companies take out loans, either from banks or by offering bonds. With equity financing, companies sell shares on the stock market or through a private offering. Debt financing allows companies to retain full ownership of the business. Equity financing distributes ownership or equity among stockholders. Companies that opt for debt financing have only to repay the monies due on loans or bonds issued without compromising any equity earned or built up in the company. With equity financing, companies may distribute a portion of any profits made to stockholders.
Key differences between debt and equity financing have to do with the types of risks involved. As debt financing uses loans and bonds as sources for capital, companies must comply with repayment schedules during periods of high and low cash flow. Ultimately, any interest costs attached to the debt increases the amount of money a company needs in order to break-even in terms of covering operations costs. With equity financing, companies have no repayment obligation, so the risks fall on the investors or shareholders. On the other hand, the more shareholders a company has the less decision-making power owners and management have over a business’ operations.
Debt and equity financing differ in how they affect the ongoing profits made through a business. Companies that use debt financing maintain their equity holdings throughout, so any profits made remain with the company. Companies that use the equity financing approach must distribute their profits to shareholders since shareholders have ownership in the company. The use of loans for debt financing also allows businesses to list interest costs as a tax write-off, which reduces the overall cost of the loan amount. Since equity financing generates the capital needed to make profits, companies can use equity financing as a way to strengthen their ability to use debt financing in the future.