Starting or growing a business eventually involves raising funds. This can be done through debt or equity financing. Most companies use a combination of the two, but the decision when to use which isn’t always straightforward.

Your business needs to strike a balance between equity and debt. Otherwise, your debt load can sink the business or you won’t have the funds they need to grow and expand. Let’s take a look at each of these options and their advantages and disadvantages.

Equity Financing

Equity financing refers to issuing stock to finance a business. Generally, it costs more to use this method as investors take on more risk. There’s no guarantee of earning a return and the stock market can be volatile.

The greatest advantage is equity financing does not place an additional financial burden on the company and there are no monthly payments. The business gains extra working capital to grow their business with the drain of debt repayments.

However, each stock represents a percentage of the company. The business must share their profits and consult with major stakeholders.  And, if not managed well, equity financing can lead to a significant loss of control and in extreme cases equity investors can seek to replace company founders.  Control and equity ownership can only be regained by buying back shares, usually at a higher cost.

Debt Financing

Debt financing refers to borrowing money and paying it back with interest, usually through a loan. It does not involve selling a percentage of the company. The relationship with the creditor ends when the loan is paid. Loan payments are predictable and interest paid is tax deductible.

However, taking on too much debt can cause a business to flounder. During periods when revenue and cash flow drops, companies may struggle to pay creditors. Companies with high debt-to-equity ratios also pay higher interest rates.

As the probability of default increases due to debt load, it can also drive down company stock prices and increase the cost of equity.

Other Considerations

The cost of financing depends on many factors. For instance, sometimes investment banks charge a higher amount to issue new stock, making debt financing cheaper. High interest rates can drive the cost of loans up, making equity financing less expensive.

Funding choices can also be affected by where a company is in their life cycle. As an example, a young business may want to issue equity to fund R&D efforts, while reserving cash flow. Retaining control is very important to some owners, making debt financing the preferable option.

Moving Forward

Finding the optimal balance act between debt and equity financing requires expertise. Businesses need capital to grow and scale, but they can’t risk taking on too much debt or blindly rely on equity financing.

In-depth financial insights and professional advice can help your business determine which works best for your organization, now and in the future. Your business can access this information through an accredited, outsourced CFO.

Let us collaborate with you to move your business forward. We provide the professional expertise you need to make wise financial decisions and our services are scalable.

Companies need to consider many factors such as existing capital structure, life cycle stage, and the current economic climate to make the right choice.  Tap into our expert financial advice, without paying for a full-time employee. Contact us for a free consultation.