Unexpected business finance solutions: Why debt > equity
By Johann S|
March 1, 2023
When you’re in charge of a young business – or if you’re advising somebody who is – you’ll always be on the lookout for business finance solutions. In the leafy undergrowth of the business world, many young enterprises are striving for a beam of heavenly sunlight (read: funding) from a benevolent celestial overlord (read: angel investor).
The story of equity financing is certainly a more attractive one. A funding narrative which features the magic words “angel investor” creates a Good Guy persona which helps the business defeat a universal enemy: debt.
Debt: the underdog in this story
The truth is, debt gets an undeservedly bad rap. Debt is often spoken about as something to be avoided or eliminated. In fact, entire agencies are dedicated to helping people defeat their debt.
To be sure, too much debt can snow businesses under and wreak havoc on personal lives. But it’s high time that we stopped regarding debt as the enemy because, in terms of business financing solutions, it’s actually an enormously helpful tool. In most scenarios, debt financing is cheaper and more sustainable than equity financing.
Not convinced? That’s alright. For people who have been trained to think of debt as something bad, scary, or a financial burden, it can be difficult to reframe the concept of debt as a tool for empowerment. Here’s how debt financing works in the real world.
Debt financing vs. equity financing
Alright, before we charge ahead with an example, let’s conduct a quick recap of what equity financing is and how it’s different from debt financing.
In any scenario, financing a company is a cost – that is, a measurable expense of obtaining capital. Got it? Good. Now, there are essentially two ways of covering this expense: equity financing or debt financing.
- Equity financing = you trade a percentage of business ownership to a stakeholder in exchange for growth capital
- Debt financing = you take out a loan from a lender, often with fixed repayment terms
We’re working with extremely simplified terms here, but here’s an example. Let’s say that you need R2 million to finance your business over 6 months. Now, you could approach an investor and sell a 25% share of the company to an investor for R2 million and zero debt, or you could take out a loan for R2 million with a total cost of finance of 10%.
In the course of the next year, let’s say that the business turns a profit of R1 million. If you took out the loan, the cost of your debt financing comes to R100k (or 10% x 1 million). So, your profit actually comes to R900k.
Right now, the equity financing option looks a lot sexier. But, if you took that option, you’ve given up 25% of your annual profits to your investor (assuming all profits are taken out as dividends). 25% x R1 million = R250k (each year!) and so, in this scenario, your profits only come to R750k.
Equity financing means you’re debt-free, but it also means that when the company starts bearing fruit, you are only entitled to a smaller share of those profits. More often than not, this division of profits means that equity financing actually costs you more in the long run than if you had just repaid a business loan.
Other factors to consider
In simple numbers, debt financing is almost always cheaper than equity financing. However, there are still more factors to consider in the comparison of one with the other.
For one, when you trade a stake in your business for financing, your investor also becomes an equity holder. That means that going forward, you’re going to have to consider their input on how the company operates – and they might not know your business like you do. If you are considering equity financing as a tool, you may need to consider if you are comfortable relinquishing a degree of control over how your company is run.
When it comes to debt financing, you enjoy more control over the terms of repayment and how your business is run. But, the terms of repayment are usually fixed – regardless of what revenue the business is bringing in. This is the primary risk factor associated with debt financing.
That being said, if the business is expected to perform well, debt financing can usually still be secured at a lower cost than equity financing. Here’s the bottom line: debt is still cheaper because, even though the terms of repayment are fixed and begin immediately, there is also a fixed limit on the amount you must pay back to the lender. Conversely, in equity financing, there is no limit to the share in future profits that investors can lay claim to in the business’s lifetime.
And that’s why debt > equity
Debt is not a bad thing. In the right hands, it’s a business financing solution that can nurture growth without compromising autonomy and control over the division of profits and how the business is run.
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