Equity versus debt financing: Which way for capital?

The two primary sources of capital to start or expand a business are debt or equity. The decision on the type of capital to use is important because of the different legal and commercial consequences for each that can influence the direction of a business for a lifetime. This article highlights some of these considerations.

Through equity financing, an entity raises capital for the business by selling a stake in the company to an investor who becomes a shareholder. The shares a company issues to raise this capital are broadly classified into two namely ordinary and preference shares.

 Ordinary shares represent an ownership interest in a company and entitle the holder to voting rights in the company and annual dividends if declared. Ordinary shareholders also have a residual claim on the company’s liquidated assets after all liabilities and superior claims have been paid at winding up or liquidation.

 Most companies have a single class of ordinary shares but it is possible to issue different classes with divergent rights.

Preference shares, on the other hand, give holders priority over ordinary shareholders in receiving dividends and claiming the residual assets of the company at winding up. Preference shares, however, do not have voting rights. Preference shares can take different forms with varying consequences.
 
 Debt financing
With debt financing, a business borrows funds from a lender that are repayable together with interest. Debt is short or long-term. 

Short term loans are normally advanced to companies to meet their day to day working capital requirements and are repayable within 12 months. 

Short term loans can take the form of lines of credit or the traditional bank loans. Traditional bank loans can be secured or unsecured. 

A secured loan is one where the borrower’s obligation to repay is secured by collateral. An unsecured loan is one where the bank disburses a loan without any pledge or specific collateral to support the loan in case of default. 

Long term loans are repayable over more than one year and mostly finance the acquisition of non-current assets. They are often secured by collateral and small companies face great challenges qualifying for them because of their lean balance sheets. 

Hybrid financing
In some instances, a business can finance its growth through hybrid financing. Hybrid financing instruments possess the characteristics of both debt and equity. An example is a convertible bond which is a debt instrument that can subsequently be converted into equity. It bears all the features of debt before conversion to equity acquiring the rights and rewards of company ownership. 

Within measured range, debt is less risky for the company and therefore less expensive to a business in comparison to equity. This is because a lender is assured of repayment especially for secured transactions. On the hand, the equity holder bears the risk of business failure thus expectant of a higher return in view of the heightened risk assumed.

Unlike equity finance that cedes away part of a business, borrowings do not dilute business ownership. The lender does not acquire ownership stake in the business. Equity financing, therefore, dilutes an owner’s control of the entity though some debt transactions impose conditions on how a business must be run a business until debt repayment.   
 
It is normally difficult for newly established businesses to obtain debt financing because of their lack of credit history and the attendant lean balance sheet. For this reason, equity financing predominates early stage businesses.

In a nutshell, it is the norm for enterprises to blend equity with debt. Within acceptable limits, debt offers the lowest cost of capital to a business because of the lower returns required by a secured lender and the tax deductibility of the interest payable. A heavily leveraged or indebted business, however, increases the bankruptcy risk to shareholders due to the cash required to service. 

In this regard, the shareholders demand for a higher return commensurate with the higher risks borne. Businesses must therefore aim to find the optimal capital structure combining debt and equity that will lower the cost of capital increasing economic returns and business value.