why do some business prefer debt financing over equity financing ?

General Information about Debt financing and Equity financing:

(Definitions)

What is debt financing?

Debt financing means borrowing money in order to acquire an asset. Financing with debt is
referred to as financial leverage. Using debt financing allows the existing stockholders to
maintain their percentage of ownership, since no new stock is being issued.

What is equity financing?

Equity financing is the method of raising capital by selling company stock to investors. In return
for the investment, the shareholders receive ownership interests in the company.

(Use of Debt financing and Equity financing)

use of debt financing:

proper use of debt financing is the potential for enhanced return on assets (ROA). For instance,
assume that a business holds large amounts of cash balances instead of using a line of credit to
assist in the financing of current assets like accounts receivable and inventory.

use of equity financing:

Equity financing, then, is the act of raising money and finances for the small business in question
through these investors. To put it simply, equity financing is the business owner giving away part
of their ownership interest in their business in exchange for money.

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The Pros of Debt Financing

1. Maintain Ownership of Your Business

You might be tempted to get an angel investor for your growing business. This is
definitely a way to infuse cash into it. But, you’ll need to ask yourself if you want outside
interference from investors? If you prefer to call the shots for your business, it makes
sense to leverage debt financing – in other words, borrowing from a bank or other type of
lender and paying it back in the agreed upon timeframe. The bank may charge you
interest on what you borrow, but they’re not going to get involved with how you run your
day-to-day operations.

2. Tax Deductions
Surprising to some, taxes are often a key consideration when pondering whether or not to
use debt financing for your business. Why? In many cases, the principal and the interest
payments on business loans are classified as business expenses. These can be deducted
from your business income taxes. In some ways, the government is your partner in your
business with a percentage ownership stake (your tax rate).

3. Lower Interest Rates

This is a somewhat difficult advantage of debt financing to understand, but it can actually
be quite valuable. Tax deductions can affect your overall tax rate. In many cases, there
can be a tax advantage to taking on debt. For example, if your bank is charging you 10
percent interest on a business loan, and the government taxes you at a 30 percent tax rate,
you can tabulate the following Take 10 percent and multiply it by (1-30 percent), which
equals 7 percent. After your tax deductions, you will pay a 7 percent interest rate instead
of a 10 percent rate. It’s a win-win financial move that lets you both get the money you
need to grow your business while also helping to slash your tax rate

The Cons of Debt Financing

1. Paying Back the Debt
Making payments to a bank or other lender can be stress-free if you have ample revenue
flowing into your business. But, what if sales are down? Or, worse yet, what if your
business should fail? You’ll still be on the hook for the debt. Business debt financing can
be a risky option if your business isn’t completely on terra firma. To add insult to injury,
if you are forced into bankruptcy due to a failed business, your lenders will have claim to
repayment before any equity investors in your business.

2. High Interest Rates

Your parents may be willing to loan you some cash at a next to nothing interest rate, but

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 don’t expect this from a traditional bank or other lender. Interest rates certainly vary on a
variety of factors including your credit history and the type of loan you’re trying to
obtain. However, even after calculating the discounted interest rate from your tax
deductions, you may still be paying a high interest rate each month that cuts into your
profits.

3. The Effect on Your Credit Rating

What you borrow does affect your credit rating. And, this effect can be negative if you’re
borrowing large sums. This translates into higher interest rates and more risk on the part
of lenders.

4. Cash Flow Difficulties

Not all businesses sell the same amount each month. In fact, most have periods of time
that are busier than others. However, lenders typically expect payment on any debt
financing in equal monthly installments. This can be a real challenge that can lead to late
payments or even defaults that can harm your credit over the long term.

Equity Financing Pros & Cons

Similar to debt financing, equity financing has benefits and drawbacks to consider. Take a look
at these pros and cons to determine if equity financing would be the smartest financial move for
your business.

Pros

Investors Take On Risk: With equity financing, the risk falls primarily on the investor.
Investors only see their returns if your business is a success.

Good For New Businesses: If you’re a brand new business with no revenue, equity financing
could be the best option for you. While you may qualify for debt financing, you’ll likely be stuck
with low borrowing limits and less-than-desirable rates and terms.

No Interest Or Fees: With equity financing, you won’t have to worry about paying interest
and/or fees on a loan or other financial product. This gives you more money to invest in your
business.

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Investors Bring More To The Table: The right investor brings more than just capital to the
table. You can gain industry knowledge, meet new connections, and gain experience that you
wouldn’t receive by working with a lender.

Cons

Giving Away Ownership: With this type of financing, you’re giving away ownership in your
business. Not only does this reduce your share of profits, but it also gives outside parties the
power to make decisions surrounding the operations of your business.

Finding Investors Is Difficult: Finding one or more people willing to invest in your business
can be a difficult and time-consuming process. If you need money quickly or with little effort,
equity financing is likely not the right option for you.

Debt VS Equity Financing

there are very clear differences between debt and equity financing. With debt financing, you
simply have to meet the criteria of a lender in order to receive money. Depending on the type of
financing you seek, you could have the capital you need in as little as 24 hours. In exchange for
this capital, you pay the lender back as agreed. You take on all the risk, so if your business fails,
you may lose your assets or face legal action.

Additionally, with debt financing, you don’t have to worry about drawing up legal paperwork.
Apply for your loan, submit the required information and documentation, and the lender will
provide you with money if you qualify. You retain full ownership of your business.

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On the flip side, equity financing could take some time. It is up to you to find the right investors
willing to work with your business. Drawing up legal paperwork will be part of the process as
well.

While you don’t have to pay your investor back over the short-term, the lender will recoup their
money if your business is successful. Because they will own part of the company, they will be
able to take their share of the profits and make important decisions about your business along the
way.

The risk is on the lender. If your business is successful, the lender gets their capital plus a return.
If your business is unsuccessful, you will not be indebted as you would with debt financing.

Which Type Of Financing Is Best For Your Business?

Choose Equity Financing If…

 You picture your business growing to a global or national scale

 You have larger capital needs that wouldn’t be satisfied through debt financing
 You’re willing to give up some control over your business in exchange for equity
 You’re looking for more than just money, i.e. industry connections and experience
 You’re willing to put in the work to pitch to investors
 Your capital needs aren’t urgent

Choose Debt Financing If…

 You have smaller capital needs

 You need capital but don’t want to give up ownership interest in your business
 You’re willing to take on risk, including losing assets if you fail to repay your lender
 You need financing quickly

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why do some business prefer debt financing over equity financing ?
Only 0.07% of business receive VC, a highly publicized form of equity financing. So, how do
the other 99.93% of businesses obtain the capital they need to grow? According to data from the
U.S. Small Business Administration (SBA), in 2013, small business owners borrowed an
estimated $1 trillion—$585 billion in business loan outstanding, $422 billion in credit from
financial institutions, and the rest from a mix of sources. This makes debt among the most
popular forms of financing; however, accessibility is just one of the many advantages of debt
financing.

Keep in mind that there are several forms of debt financing, including lines of credit, small
business credit cards, merchant cash advances and term loans. Make sure to explore all of your
options for debt financing and select the one that best matches the unique needs of your project.
While a term loan is appropriate for long-term growth investments, such as hiring more full-time
employees or opening a new office or retail space, a line of credit is best suited for businesses
looking to cover expenses that can be repaid within 12 months.

Whether you choose a term loan or line of credit, debt financing offers several benefits. From
maintaining control of your company to receiving tax breaks, let’s review the six advantages of
debt financing.

Why they choose debt financing?

Ownership Stays With You

If you have followed the TV show Shark Tank, then you’re familiar with the haggling process
after the business owner’s pitch, in which investors offer (and adjust their offers) for upfront
capital in exchange for equity (check out a sample deal negotiation with inflatable pad
manufacturer, Windcatcher). While the Wind catcher owner was lucky enough to receive a deal
with a lower equity stake than he was willing to give up, he still has to part ways with 5%
ownership in his company. When seeking equity financing, other business owners may not be as
lucky and have to give up a 10%, 15%, or even 20% stake of their company for an investor to be
willing to fork out cash.

With debt financing, you don’t have to give out a stake in your company. Under certain
circumstances, you may have to use a piece of machinery, vehicle, or very liquid accounts
receivable as a collateral for a loan, but you only would have to give up ownership of that
collateral if you were to default on the loan. Ownership of your company stays with you.

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Current Management Retains Full Control

With company ownership comes control over management decisions. Depending on how much
ownership you give up to third parties in exchange of equity financing, you’ll find yourself being
less nimble to make decisions on your own. You often will have to seek approval for a mutually
agreed list of items, ranging from hiring new personnel to selecting vendors. Virtually all equity
investors seek some level of authority in the decision making process of companies that they
invest in.

On the other hand, a lender has no say in how you run your small business. They may still want
to take a look at your financial statements to perform a cash flow analysis, but they won’t have to
approve on your purchases of supplies or hiring decisions. As long as you meet your scheduled
payment plan on time, they’ll be happy to let you run your business as you wish.

Interest Payments Are Tax Deductible

Regardless of whether they’re charges from a term loan, line of credit or working capital
account, any interest paid on money that you borrowed for business activities is tax deductible.

On Chapter 4 of Publication 535, the IRS indicates that you can “generally deduct as a business
expense all interest you pay or accrue during the tax year on debts related to your trade or
business” as long as the loan proceeds are used for business expenses and:

 You are legally liable for that debt;

 Both you and the lender intend that the debt be repaid; and
 You and the lender have a true debtor-creditor relationship.

This deduction is available for all types of small businesses. Here are some examples:

 Sole proprietors can deduct interest as a business expense on line 16 of Schedule C –

Form 1040 and owners of partnerships.
 Owners of partnerships can claim this deduction on line 15 of Form 1065.
 Owners of S Corporations can claim this deduction on line 13 of Form 1120S.

Many types of charges from your lender for financing or refinancing a loan—including
origination fees, maximum loan charges, discount points, or premium charges—can also help
you to lower your business tax liability. Certain limitations may apply, so consult IRS
Publication 535 or contact your accountant for more details.

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Taxes Lower Interest Rate

Due to the tax advantages of debt financing, you’ll need to adjust your interest rate when
comparing debt financing to alternative financing options.

Let’s imagine that you were evaluating whether or not to take a loan with an interest rate of 14%.
Assuming that your business tax rate was 25%, your after-tax interest rate is 10.5% (14% – (1 –
25%)). When bringing taxes into the picture, 10.5% would be the actual interest rate that you
would need to use in forecasts about your business. This is one of those times in which taxes can
actually help you improve your bottom line.

Accessible To Businesses Of Any (And Every) Size

While there are alternative ways to raise funds, many of them aren’t accessible to small business
owners. Here are two examples that speak to the advantages of debt financing.

First, in 2012, only 2% of small businesses listed venture capital as a source of funding,
according to data from the U.S. SBA. On the other hand, 87% of small businesses listed debt
financing as a source of funding. One key reason is that venture capitalists are looking for the
next “unicorn” (companies with an estimated valuation north of $1 billion) and that disqualifies a
majority of small businesses, even those with a positive cash flow history.

Second, while sole proprietorships aren’t prohibited from issuing bonds, very few can comply
with the mandatory federal regulations and cover the associated expenses with the process of
issuing bonds. If you think meeting the necessary requirements for an asset-based collateral loan
can be hard, then complying with the more stringent collateral requirements for issuing bonds is
virtually impossible.

On the other hand, even the smallest of small business can shop around for some form of debt
financing.

Builds (Or Improves) Business Credit Score

Making timely payments to your lender of choice serves as a way to improve your personal
and business credit score, another example of the advantages of debt financing.

It’s a great practice to separate your personal from your business finances, but it’s an even better
one to separate your personal credit score from your business credit score. A great business
credit score demonstrates vendors and lenders alike that you are responsible business owner, and
that your business’s cash flow is sufficient to meet its obligations. Even when a lender doesn’t

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report to a business credit bureau, having a financing contract and a record of payments may lead
to better financing opportunities.

Being responsible with debt financing can help you boost the creditworthiness of your business.
As your business credit score increases, so will your business credit offers. Having access to
better debt financing, can help you cover any future cash crunches more efficiently.

Final Thoughts
There are many ways to get capital for your business through debt financing or equity financing.
However, it’s very important that you weigh out the pros and cons and consider the specific
needs of your business before moving forward. While your capital needs may be urgent, it’s
critical to look at the long-term picture to determine what type of financing will most benefit
your business.

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Reference:

Websites:

1. Merchant maverick blog

2. Kebbage.com
3. Bondstreet.com

Books:
1. Ibbotson and Brinson, 1993, Global Investing, McGraw-Hill, New York.
2. Bierman, H. and S. Smidt, 1992, The Capital Budgeting Decision, Macmillan Company,
New York.
3. Clark, K.B. and T. Fujimoto, 1991, Product Development Performance, Harvard
Business School Press
4. The Changing Nature of Debt and Equity: A Financial Perspective, by Franklin Allen.

Journals:
Damodaran, A., 1999, Financing Innovations and Capital Structure Choices, Journal of
Applied Corporate Finance, v12, 28-39

(This document contains 2850 words)

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