Debt and equity are essentially the ways in which companies can raise capital. Debt financing is when a company takes out a loan that generally has a defined time period and interest rate attached to the transaction. Debt financing include loans, leases, bank overdrafts and terms of trade. Next, equity financing is when a company issues shares to the other investors which can be the general public or investment companies. These shares represent ownership of the company to the extent of the shares held by the person; in essence it is like selling off little bits of the company.
People who purchase equity shares may therefore receive a distribution of profit made by the company known as dividends or sell their equity in the company to other investors. Debt and equity financing provides an opportunity for the merchant to attain funds for the startup of his business. Equity financing, however, are more attractive for many people who are just starting out. The concept of equity is that the merchant is selling stocks to investors.
If a person is to decide between debt and equity financing, he must consider all the risks and advantages he must take. Both debt and equity financing have their own advantages and disadvantages. If we have to choose between debt and equity, we must consider the consequences. In debt financing, one must pay for his debts plus interest. It would mean relinquishing some of his profits for payments of his debt. The advantage, however, is that we get to retains full ownership of our business.
Another advantage is that business loans are generally tax deductible. This may help us to pay less tax while we are in debt. In debt financing, everyone must provide collateral whether it is property or investments that can be secured in case of failure to repay debts. The agreement in debt payment may be short term or long term. It is considered short term if the agreement must be paid in one year or less. If it is more than one year, then it is already considered as a long term debt.
However, in equity financing, we are not obligated to pay for the equity. If there is no profit, we shall pay our investors nothing. That is the main advantage we could get in this equity financing. The disadvantage in equity funding is that we are not the sole owner of our company. The money that we received is exchanged with rights of ownership over our company. We will be sharing financial and execution control with the investor. Moreover, there is a risk of losing control over our company.
In the future, we may also be obliged to pay dividends to our shareholders. Dividend payments are not tax deductible. Which is best; debt or equity financing? In my opinion, it is always depending on the situation. Your financial capital, potential investors, credit standing, business plan, tax situation, the tax situation of your investors, and the type of business you plan to start all have an impact on that decision. The mix of debt and equity financing that you use will determine your cost of capital for your business.