Debt vs Equity Financing
Equity is the worth of an asset minus the total of all liabilities on that asset.
Equity Financing is the course of increasing capital by the sale of shares in a business. The sale of ownership parts to increase finances for the purpose of business is equity financing. Equity financing has a broad spectrum to increase ownership shares. Friends and family members can be asked to invest funds and get ownership shares accordingly. Giant initial public offerings can be made to raise funds from millions to billions. Financing from other private companies can also be considered in equity financing. Equity financing is different from debt financing. Debt financing is made when money is borrowed and has to be paid back, usually with interests.
Debt is the money borrowed by an entrepreneur to use in funding a business that he/she could not afford under normal conditions. A debt arrangement means that the borrower is given money under the condition that borrowed money will be paid back at a later date, usually with interest. There can be different types of loans. Debt can be issued either to an individual borrower or to a business.
In certain cases, borrowing money is much better than giving up equity.
Reasons Why Borrowing Money Is Usually Better Than Giving Up Equity1. When taking debt, the lender has no claim to equity in the business. Ownership remains the same. Business operation and bookkeeping decisions remain with the owners/entrepreneurs/executive management. Equity charges a part of your business, forever. Equity financing divides the ownership of a company.
2. When net profit is increased, the lender will only be given the borrowed money and the interest in it. If business progress and rewards are larger, the entrepreneurs will reap the rewards. The lender will have no claim or share in the business rewards/profits. But if you go for equity financing, in the long run, the shareholders will be getting the share in net profits. In short, future profits will be distributed among equity holders and your profit share will be reduced.
3. Interests on debt can be subtracted on the business’s tax returns. Borrowing money can be a gift to entrepreneurs. The cost of interest decreases taxable profit that your business earns, thus it reduces the tax expense in your company/business. Large corporations/businesses also use this strategy to reduce the tax expense. If you get cash from equity instead of debt, then you will be paying off the cash to the equity holder for your business. But when debt is taken, the interests are deducted from the taxable profit. So, the expense of interests is reduced and the debt will also be paid back eventually.
4. There will be no need to seek the vote of shareholders in the business for making certain decisions. Debt is good if you want to keep the business and the whole ownership with you. In the case of equity financing, the shareholder’s vote will be compulsory in making decisions for the growth of business, investments, expenses and other internal decisions.
5. Debt boosts discipline and discipline ensures success. Debt brings about a discipline in spending and reduces expenses in the company. Debt is not merely taken to increase discipline, but it is also a plus point in holding unnecessary expenses in the business. A check and balance system is maintained on business bookkeeping. Cash flow is regularly matched with financial statements and balance sheets. Business operations are routinely done.
It is a myth that debt is never good in any kind of business or situation. Many times, debt is proven to be better than giving up equity. Debt can be paid back. But once the equity is given, other shareholders in the company appear.
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