There comes a time in every business when funding is required. Capital is a crucial financial resource that a business need for various reasons, such as maintaining the operations of the business and purchasing assets. Here we discuss the two primary methods through which a business can raise funds: equity financing and debt financing. You must evaluate and decide to choose a way to raise finances is a common dilemma that founders undergo.
Equity
Equity is a method of raising funds wherein the entrepreneur exchange capital for ownership rights in the business. In the case of equity financing, a company asks people to pay a sum as capital in exchange gives them ownership rights. Equity investors own a piece of your business. This method is advantageous because one does not have to pay any interest to the investors. Moreover, the money does not need to pay back either. Investors get dividends when the company starts making money if at all it does. There is no involvement of liability in raising capital as there is no repayment to investors.
Equity raises far more money than debt financing and takes the pressure of loan repayment off the business owner. It is a viable option because it is very flexible. Although, the fear of every business owner is and should be giving up control. Decision-making power may diminish with this option and could affect the business negatively.
Debt
Debt is the amount of money a debtor (borrower) owes to a creditor (lender). The principal amount borrowed is paid back to the creditor with interest. It is the complete opposite of equity financing.
In this method, ownership of the business is untouched and remains with the owner. The bank or institution/individual does not own any part of your business. But the drawback of this method is that interest has to be paid along with the principal amount, usually monthly.
The pressure of repayment could drive some business owners to take rash decisions. The lending requirements are usually strict for start-ups. And the loans may have to be paid right away. It would reduce the cash borrowed almost instantly. There is a liability on the part of the business owner. At times, lenders ask for personal collateral.
If in case, where the business does not do well, it may lead to the liquidation of personal assets. Once the borrowed amount is paid back to the creditor, the liability ends. Every profit by the business stays within the company in this method of debt financing.
Which method of raising funds is best suitable for you?
As an early-stage start-up that does not require a hefty sum, the best method would be debt financing. It is because, at this tender stage, raising funds through equity financing may propose to be a challenge.
Giving up ownership rights at the initial stage for an extensive portion of the business may not fare well in the long run. After a certain period, when the start-up begins to do well and requires funding, it could look into equity financing.
Financing is a decision you take at some point as a business owner. While doing so, a business owner must outweigh the pros and cons of every method of financing. You must understand the advantages and disadvantages of raising funds through these sources before the search for money begins. While analyzing the pros and cons, one must understand what will be the most beneficial for their business. If you are well-informed, you will likely make the right choice.
FAQ
1. Which is better- equity or debt?
The company is accountable to its shareholders, who require constant profits to maintain a stock valuation and pay dividends. The cost of equity is generally higher than the cost of debt because equity financing carries a higher risk for the investor than debt financing for the lender.
2. What is the difference between equity and debt?
Where you invest the money is the distinction between the two. Equity funds engage primarily in equity shares and related securities, whereas debt funds invest in fixed-income instruments.
3. Why is debt preferred over equity?
Companies may choose debt financing over equity financing for a variety of reasons. A loan does not provide an ownership stake and hence does not dilute the owners' equity position in the company. If the company grows, debt may be a less expensive source of growth capital.
4. How do you decide between debt and equity financing?
Long-Term Goals
Available Interest Rates
The Need for Control
Borrowing Requirements
Current Business Structure
Future Repayment Terms
Access to Equity Markets
5. Which is cheaper- debt or equity?
Since debt has a low risk, it is frequently less expensive. Owners of stock are taking on risk. As a result, they get compensation with higher returns.
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