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In Short
- You can raise business capital through debt financing (borrowing money) or equity financing (selling ownership shares).
- Debt requires regular interest payments and repayment of the loan, while equity dilutes ownership but does not require repayment.
- Each option has different implications for control, cash flow, and cost of capital; many businesses use a mix of both.
Tips for Businesses
When deciding between debt and equity, assess your company's cash flow and tolerance for ownership dilution. Consider how interest payments might affect your finances and whether giving up control to equity investors aligns with your growth plans. Speak with financial and legal advisers to understand covenants, repayment terms and shareholder rights.
Summary
This article explains the legal and commercial differences between debt and equity financing for business owners in the United Kingdom. LegalVision's business lawyers, a commercial law firm specialising in advising clients on raising finance and funding structures, outline the practical considerations and trade-offs involved in choosing between debt and equity.
Are you a business owner looking to grow your company? Perhaps you have a compelling idea andhave taken the first steps to implement it, but need money to scale? You probably know there are two ways your business can acquire capital (i.e., money): debt and equity. You also know how these operate. Equity investors give your company money in exchange for acquiring shares of ownership, while debt financiers are typically banks that lend your company money in exchange for repaying the loan plus interest. This article explains key legal and commercial considerations you shouldevaluate when deciding between debt or equity financing.
Overview
The critical distinction between equity and debt financing is that an equity investment dilutes your share of ownership in the company. In contrast, a debt investor will charge you interest for the privilege of lending your company money.
In other words, the disadvantage to equity financing is that you lose a portion of ownership in your company and the amount you share in the company's profits. So, effectively, you will have less control over how you run your business.
Likewise, debt financing requires that your business pay an additional amount of money (interest) in addition to the amount you have borrowed.
We will explore the advantages and disadvantages of each in more detail.
Cost of Capital
Each kind of financing has its own cost of capital.
Equity
For equity, your company's shareholders will be entitled to receive a share of your company's profits based on the number and type of shares they own.
Speaking practically, equity investors in early-stage businesses tend only to invest in companies if they have preferential rights to dividend payments. Therefore, not only will your company have to turn a profit, but the preferential shareholders will have to be paid in full before you and the company's other founding shareholders get your share of the profits.
At the same time, because you are only paying your equity investors out of your company's profits, this may be cheaper than debt financing.
Debt
For most small and medium-sized businesses, debt financing is almost always conditional on paying interest on top of the amount borrowed. For a debt investor, such as a bank lender, the riskier they perceive the investment, the more interest they charge.
As an example, an overdraft facility may permit you to borrow up to £10,000 with a 10% equivalent annual rate (EAR) assessed each day there is an outstanding balance. However, if you borrow the total amount and it remains outstanding for the year, you will have to pay £1,000.
Therefore, this often means that debt financing is more expensive than equity in practice.
Investor Expertise
As a condition of an equity investment, your investor may acquire a seat on the board of directors. While this can limit your control in the company, they will have a vested interest in your company's success. In addition, this means they will ensure your business has access to their expertise and network.
A lender is far less likely to give your company commercial and strategic advice.
Cash Flow
In the context of financing, cash flow refers to the obligations to make outgoing payments to your investors.
Equity financing gives you more freedom to control your company's cash flow because dividend payments are at the discretion of the company directors. You may decide that you should not pay a dividend in the first year following an equity investment and instead reinvest the money.
For debt, you must make interest payments according to the loan terms. If you do not, you will be in default. Therefore, you must maintain adequate cash to pay interest payments, which is money you cannot apply elsewhere.
Loan Covenants
Loan covenants are legal promises you make to your lender not to do certain things. You may promise not toborrow more money or enter into any other security agreements. If you breach these covenants, this may be an event of default that permits the bank to order your company to repay the total amount of the loan.
Equity financing does not contain any covenants (though there may be shareholder agreements with similar effects).
Deleveraging the Capital Structure
If your business already has lots of debt, you may not be able to take on any more loans. Therefore, equity financing may be your only option if you need to raise money. If you successfully raise equity in your company, it will be more valuable, which will mean that the ratio between your debt and value will decrease. This is called deleveraging.
Your company's capital structure refers to the kinds and amount of debt it has issued relative to the value of its equity. An accountant or corporate financier can advise on the best balance of debt and equity.
Tax Benefits
You do not have to pay tax on the money you have paid towards interest. However, if you declare a dividend, this will be paid out of your company's profits, which is taxed at the corporate tax rate (19%).
This means that you can offset the cost of borrowing from your taxes, which your company may find advantageous.
"Juicing" Returns
Depending on how you apply the money raised through debt financing, you can increase the rate of return on the investment compared to if you had just used the company's own cash (such as what was raised by equity financing).
For example: let us say that you want to buy a machine that would increase your company's profitability by £100,000 in a year. However, the machine costs £50,000.
You could raise cash through equity financing and use all the proceeds to buy the machine. In a year, the return on your investment would be double what you initially paid.
Alternatively, you could raise £40,000 through a loan and use £10,000 in cash to pay for the machine. After you pay the loan back, not accounting for any interest, your return would be six times your cash investment (£60,000 divided by £10,000).
This is why most companies usually have some amount of outstanding debt: it is an effective way to grow your business.
Key Takeaways
You can raise money for your company through debt and equity. In practice, there are advantages and disadvantages to both. Firstly, you may not have access to equity investors until you implement your business plan. Therefore, you may need to borrow money from a bank first. However, later on, the cost of capital for equity financing may be cheaper than for debt. Furthermore, you will not have to abide by loan covenants or tightly manage your company's cash flows under equity financing as you would for a loan financing. Generally, businesses use both equity and debt financing to maximise their financial position.
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Frequently Asked Questions
Is debt or equity financing better?
The answer depends on your company's needs, such as how long it has been trading and its capital structure. Again, an accountant or banker can advise you on the best balance.
What are the advantages and disadvantages of debt and equity financing?
Broadly, debt financing means you do not lose ownership of your business, but you will have to pay interest, increasing the cost of capital. On the other hand, equity financing means you lose ownership, but it can be cheaper.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
