Whether you’re just starting your business or looking to expand, you’ll eventually run into financing questions. Should you take out a loan or look for investors to raise that extra capital you’re seeking? The route you take will result in big consequences for you in the long run. So, should you opt for debt or equity?
Debt financing involves borrowing funds to be repaid at a later date at a defined interest rate. Debts are commonly in the form of either loans or credit. The benefit of debt is the large infusion of cash that allows the business owner to grow in a way that might be otherwise impossible. Even better, the entrepreneur gets to retain full ownership and control of his/her business.
The cost of debt is the payment of interest. Whether the business eventually thrives or fails, you have to repay your lenders.
Equity is simply funds generated by the sales of a company’s stock. The benefit of equity is that irrespective of the business’s outcome, you do not have to repay the money. However, it shouldn’t be seen as a generous donation.
First off, investors are given a cut in your company for the risk they’re taking to back you up. Since investors are particularly concerned about maximizing returns, there’s always the pressure to surpass their expectations – generate consistent profits, maintain high stock valuation, and pay dividends.
Generally speaking, the cost of equity is higher than the cost of debt due to the higher risk associated.
Understanding Capital Structure
Capital structure is the specific combination of debt and equity used by a company to finance all of its operations and growth.
The best metric to understand the optimal capital structure is the ‘Weighted Average Cost of Capital (WACC)’. WACC simply represents a firm’s blended cost of capital including equity and debt. In simple terms, it measures the contribution of equity and debt to a company’s capital.
As you may recognize, the goal should be to minimize WACC.
Two factors can result in high WACC.
1) High debt and low equity
2) High equity and low debt
Consequently, a company’s capital structure should consist of a balanced combination of debt and equity.
Why Too Much Equity is Expensive
As noted earlier, the cost of equity is higher than the cost of debt because of the higher risks investors take when they give you money (if your business goes south, you do not have to repay them).
To compensate for this risk, equity investors will demand higher returns compared to an equivalent bond investor when he/she is purchasing your company’s stock.
Here are some of the reasons investing in stock is riskier:
1) Higher volatility of the stock market.
2) Stockholders have a lower claim on your company’s assets if you default.
3) Returns are not guaranteed.
4) Dividends can be low or absent if the company is faring poorly.
Therefore, funding with only equity will result in a high WACC.
Why Too Much Debt is Expensive
On the other end of the spectrum, we have funding purely with debt. While the cost of debt is lower than the cost of equity, this relationship reverses when you take too much debt. The greatest factor affecting the cost of debt is the interest rate.
Think about it, as you accumulate debt, the probability of defaulting increases. To compensate for this increased risk, interest rates increase. This results in a downwards spiral. If the company experience a slow sales period, it won’t be able to generate enough cash to make monthly payments, and might eventually default.
Thus, too much debt isn’t good because it increases WACC.
Optimal Capital Structure.
The optimal capital structure is peculiar to a company, and it represents the unique combination of equity and debt that minimizes the Weighted Average Cost of Capital (WACC).
Factors to Consider Before Choosing a Financing Option
Here are some general principles to guide you to decide when equity is preferable to debt and vice versa.
- How soon do you need financing?
If you need quick cash, debt financing is the best option. Equity financing takes time to secure – from finding the right investors to drawing a comprehensive business plan to pitching to investors, and more.
- How much do you need?
If you’re looking for a small amount say < $10,000, then you shouldn’t bother yourself with equity. Equity investors typically invest upwards of $100,000.
- Are you looking for more than money?
If you want ‘smart’ money – i.e., money that comes with advice and network – then equity financing is the way to go. Equity investors bring in their unique experience, expertise, and can link you with their vast network.
- Does control mean a lot to you?
If you like to run your business without the interference of any third-party, then debt financing is the best option. You get to retain absolute control and ownership of your business.
- How volatile are your earnings?
If your profits are unpredictable or seasonal, you’ll likely default on monthly debt payments. In such cases, opting for equity may be a more prudent choice.
- How intense is your R&D?
For a startup company with a serious focus on R&D, profits may be more of a long-term objective. Monthly payments for debt financing will only detract from the cash flow that should be invested in further research. This makes equity financing a better option.
- What is the interest rate?
If the interest of debt is too high, then it probably means the cost of debt is higher than the cost of equity. In such a scenario, equity financing may be better. Questions or concerns? Reach out to us today for more information.