How to Determine Whether Debt or Equity Financing Is Right for You
Although debt and equity are often used together to fund new or existing ventures, they are different financing methods with distinct advantages and disadvantages.
In recent years, new providers and funding models have become available in both the debt and equity markets, increasing both the range of choice and the complexity of the financing process. To ensure the success of any initiative, it’s now more than ever essential to review all available options for your business.
Debt and Equity Financing – Some Key Considerations
Debt financing (also called loan financing) is probably the simplest option for most established businesses. Apart from the relative ease of the process, the main advantage is that all equity and ownership rights in the business remain in the hands of the existing owners.
In times of low interest rates, debt may be a relatively cost-effective means of obtaining working capital, and interest payments are usually tax-deductible. However, you must also consider the rigidity of the repayment schedule and its potential impact on future cash flows.
Current owners of a business looking to maintain or increase the value of their interest, or expand operations long-term, need to bear in mind that the debt-to-equity (D/E) ratio of the business is a key metric in market analysis. If this ratio becomes too high, it may deter future buyers or investors and hinder the development of the business.
Depending on the market sector, startups or businesses looking to expand rapidly may find it difficult to obtain debt finance at an acceptable cost. This, of course, also applies to established businesses that may experience cash flow difficulties.
The use of commercial mortgages, in which the company’s or directors’ personal assets become security for loan finance, may help offset some of these problems. However, these arrangements frequently involve new and serious risks of their own.
The term “equity financing” covers a wide range of funding initiatives, from relatively small private finance projects to multi-billion dollar IPOs for the shares of established name brands.
Flexibility is a key advantage of raising funds through equity. Businesses can choose various forms including common stock, preferred stock (which may or may not be convertible) or warrants, depending on investor preferences and attitudes about risk.
Of course, these preferences are likely to change as a business develops, so using a variety of equity funding models allows for the employment of new and different sources of funds as requirements change.
Perhaps most importantly, although investors will expect an eventual return, raising capital through equity generally allows a business considerable discretion in the amount and timing of dividend payments. This can be a way of managing cash flow that isn’t usually available to those who use debt finance.
On the other hand, dilution of the interests of the founders and existing owners of the business, and the consequent reduction of their share in its future profits, is the principal disadvantage of equity financing. But the process of issuing shares or other equity instruments is highly regulated and legally complex, particularly if shares traded on a public exchange are involved. Therefore, business owners need to consider whether the amount of capital they can likely raise is sufficient to justify the time and money needed.
The Choice Between Debt and Equity Financing
The choice between equity and debt financing is likely difficult, and most businesses will employ a combination of funding sources at different stages of their development.
The ability to accurately calculate, forecast and compare the true cost of capital that a business will incur under different funding models is vital for sound planning and safe expansion. Corporate finance professionals have a number of tools at their disposal to assist in the process.
How to Calculate the True Cost of Business Capital
One of the most important of these tools is the weighted average cost of capital (WACC). The detailed calculations are complex but essentially involve giving a weighting to each element of a company’s capital, such as common and preferred stock, and any debt capital in the form of loans or bonds issued.
The weighted amounts are then combined with the actual or projected cost of the debt and equity carried by the business to give a percentage figure for its overall cost of capital.
The figure is useful to market analysts and investors who wish to know the real rate of return that a business generates.
In general, the higher its WACC, the higher the perceived risk a business represents for investors. So companies whose WACC appears high when compared with similar enterprises in its market sector may well need to reduce it in order to attract new equity investors. The figure is often also an essential element of any application for loan finance.
Knowing the WACC of a business and the way in which the different elements contribute to it, is an important first step in any attempt to restructure a company’s financing or to increase its capital base.
As a simple example, it may be sensible to consider buying back common stock using the proceeds of a bond issue if the interest rate payable on them will be less than the return demanded by equity investors.
The Financing Process
However, to achieve the optimal blend of debt and equity always requires a thorough assessment of a company’s existing capital structure, its operations and its future objectives. Consider the best way to meet future capital needs alongside any rebalancing or restructuring that may be necessary to optimize current cash flows.
Moreover, in today’s dynamic capital markets the range of possible funding sources is expanding rapidly. In addition to traditional sources of commercial funds, it’s now possible to raise debt or equity capital directly from a variety of private institutional investors and funds. Corporate bonds or stock may also be sold through public offers.
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With so many options now available, knowing who to contact, and how, is at least as important as a thorough understanding of the technical issues involved. The correct preparation and presentation of the detailed financial analysis is crucial to the successful marketing and completion of any project.
At Scott-Macon, Ltd. we have more than 40 years’ investment banking experience, and debt and equity financing services are one of our core specialties.
Our overriding aim is to provide all our clients with top-quality individual service, precisely tailored to the specific needs of their business.
We’ve advised firms in a wide range of sectors including health care, the auto industry, transportation, defense and retail, to name but a few. Many of our top executives have significant direct experience in these industries in addition to their financial expertise.
For an exploratory discussion of your goals and to learn more about how we can help you achieve you them, call 212-755-8200 or contact us online.