Founders, especially those with no previous entrepreneurial experience, need to be wary and cautious with each move
Evaluate which of the two options — debt funding or equity funding — should be chosen to avoid losses
Wha are the major differences between debt funding and equity financing?
It’s the eternal questions for startups that have progressed past the early-stage growth pains and are ready for expansion. Among the many options available for Indian startups and their founders, the debate of debt funding vs equity funding has been going on for many years.
Ready with a fresh idea and a lot of enthusiasm, first-time entrepreneurs are eager to join the startup game. Most can’t wait to get running, but the truth is that troubles in the initial phase often prove fatal for most startups. Founders — especially those with no previous entrepreneurial experience — need to be wary and cautious with each move they make, as at an early stage most aspects of the business are crucial in securing funding.
Startups cannot simply rest on the uniqueness of idea or the hard work being put in, the inflow of funds is directly linked to the probability of success or failure as well. And these days as the Indian startup ecosystem has matured, startups have plenty of avenues to get started. From bootstrapping to seed funds to angel investments, early-stage startups have a plethora of options.
But when the need of the hour is big funding, startups usually have to turn to VCs or institutional investors, which typically results in some stake or equity being sold by the startup. In the long run, having multiple VC funding rounds will hold the business in good stead, but it also takes away the autonomy of the founder.
So in some other cases, entrepreneurs and founders may resort to debt funding which is considerably less risky for the investor but adds more pressure on the founder and startup than equity financing. That’s because founders have to pay back the debt and this puts revenue pressure on the company.
So clearly, startups need to evaluate which of the two options — debt funding vs equity funding — should be chosen to avoid losses, undue pressure or hassles in future. Here’s what sets equity funding apart from debt funding.
Debt Funding Vs Equity Funding
To understand the differences in debt vs equity financing, one needs to know and analyse what these things are. Equity financing takes place when an investor or a venture capital firm invests funds in a startup, with a motive of earning back a multiplied amount of the investment made in the form of returns. In this case, the startup doesn’t need to pay back the fund invested to the investor but instead has to part with a chunk of company shares and give it to the investor. This company share is called equity, thus naming this funding process equity financing.
In case of debt financing, the investor or venture capital firm basically lends money to the entrepreneur, against a rate of interest, for a given period, with company assets as securities. Here, to borrow the fund, the founder sells company bonds which acts as a certificate of loan. There is no question of the investor acquiring company shares, but the startup has to repay the amount borrowed along with the interest at predetermined rates. Investors also ask for a company or the entrepreneur’s assets as security for the loan repayment and might well put forward certain terms and conditions for debt financing.
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Going by the definitions, it’s easy to understand the differences in debt funding vs equity funding. Firstly, while in equity financing there is no component of repayment of amount, which puts less pressure on the startup for revenue, but does bring in added pressure from investors for growth and future revenue. Debt financing requires the invested funds to be repaid within a certain period, so this brings a lot of revenue pressure on the startup and is usually opted by those businesses which have a steady inflow of revenue such as lending tech companies, which get repayments from customers on a monthly basis, part of which can be used to pay back the debt.
Another thing to consider is that debt financing gives the investor no rights in terms of demanding revenue or returns as long as the debt is being repaid duly. But since equity financing lets the investor acquire company shares, they become part of the board of directors and have a say in business decisions and company strategies.
Thirdly, in debt financing, non-repayment of the loan, company closure or business failure, the investor can get back the money by seizing startup assets kept as security, and in this case, the investor is one of the first debtors to get back the funds invested. But there is no such assurance in case of equity financing, thus making the investor intervene in business decisions to secure their returns. In the context of equity funding, due to the structure of VC funds, the VC investor in a startup usually is the last to get the returns after it has paid off the limited partners in the fund.
Lastly, to cover up or compensate losses, debt funding enables investors to lend funds at a high-interest rate, as investing in startups is a risky affair given the high failure rate. Equity fund investors, on the other hand, dictate terms and have a say in business decisions to ensure high returns as dividends of the company profit. In case of losses, they have to cover it up by earnings from other investments in its portfolio.
Equity Vs Debt Funding: Tenure, Profits And Repayment
The funds for startup differ in terms of usage, tenures and nature making it easy to trace the comparison of equity vs debt funds. Let us now point them out one by one.
In debt funding vs equity funding, the equity route is meant for different stages of the startup’s journey. In the initial years, the funds are provided to help companies grow in terms of productivity, business development, meet customer demands and start earning a profit. Thereafter funds are meant for widening the market base, get new customers and cover higher demands, thereby registering a higher profit margin. At the later stages, the funds are targeted towards upscaling of an already successful startup, through diversification of product, expansion to new markets and achievement of business goals such as IPO, merger with bigger companies or acquisitions, that lead to a successful exit of the investor.
Meanwhile, debt funds have no specified stages and can be raised at any point of the business, depending on the monetary needs. Usage of debt funding varies in terms of requirements such as capital costs incurred in setting up, infrastructure, equipment or additional capital requirement for growth, expansion or diversification, as well as recurring costs like salaries, rents or maintenance.
In comparing equity fund vs debt funds, tenures are usually longer for equity funds, while debt funds are categorised into short term and long term. Long term debt funds are raised for capital costs which have high-interest rates, and have company assets as collateral. Whereas short term funds are utilised in recurring payments, have lower interest rates and minimal collateral requirements. Moreover, equity funds take away the autonomy of decisions from the entrepreneur while debt funds let them have freedom of strategising their startup in their own way.
Challenges In Debt And Equity Funding
Understanding the debate of debt funding vs equity funding is of immense importance for a first-time entrepreneur in his startup. While startups generally have a higher probability of failing, the inexperience of the founder can also lead to wrong business decisions and losses. In this case, both equity and debt funds become a huge concern in their own way. So, comparing equity fund vs debt fund is the only way that would help the entrepreneur assess, which one is the best fit at his position and can assure success. One has to carefully consider if he is comfortable in parting with company shares and autonomy of business decisions, and raise equity fund or get a debt fund, which has to be repaid at any cost.
Another big challenge is the first-time entrepreneurship in case of startups. It, thus, makes it very difficult to raise any kind of funding, be it equity or debt, as the investor fears losses due to inexperience of the entrepreneur. To ensure returns in case of equity funding and on-time repayment of debts, investors tend to prefer experienced business owners instead of inexperienced entrepreneurs. The key factor, therefore, remains the power of the business idea.
FAQs
Which is better debt funding or equity funding? ›
In general, taking on debt financing is almost always a better move than giving away equity in your business. By giving away equity, you are giving up some—possibly all—control of your company. You're also complicating future decision-making by involving investors.
Do you think debt financing is better than equity financing? ›Debt financing can be riskier if you are not profitable as there will be loan pressure from your lenders. However, equity financing can be risky if your investors expect you to turn a healthy profit, which they often do. If they are unhappy, they could try and negotiate for cheaper equity or divest altogether.
Why do startups prefer equity over debt? ›Dividend is subject to tax and is a cost to the company, unlike debt, where interest on the loan is tax deductible. But with equity financing, there is no obligation to return capital, especially if there's no profit, and this becomes a key advantage for startup companies in terms of keeping their costs low.
What are the advantages and disadvantages of debt financing of equity financing? ›Because equity financing is a greater risk to the investor than debt financing is to the lender, debt financing is often less costly than equity financing. The main disadvantage of debt financing is that interest must be paid to lenders, which means that the amount paid will exceed the amount borrowed.
Why is debt better than equity? ›Reasons why companies might elect to use debt rather than equity financing include: A loan does not provide an ownership stake and, so, does not cause dilution to the owners' equity position in the business. Debt can be a less expensive source of growth capital if the Company is growing at a high rate.
Which is riskier debt or equity? ›The main distinguishing factor between equity vs debt funds is risk e.g. equity has a higher risk profile compared to debt. Investors should understand that risk and return are directly related, in other words, you have to take more risk to get higher returns.
How do you decide between debt and equity financing? ›Income Generated: Income is the most important factor to consider while choosing between debt and equity. Income is both considered by lender and investor. If a company will not have sufficient income it will be difficult to repay the loan in future else another alternate is to go for private equity.
Which is cheaper equity or debt? ›The Cost of Equity is generally higher than the Cost of Debt since equity investors take on more risk when purchasing a company's stock as opposed to a company's bond.
What are the advantages of debt financing over equity financing? ›Advantages of debt financing
Maintaining ownership – unlike equity financing, your business retains equity which means you continue to have complete control over your business. As the business owner, you do not have to answer to investors.
If your company is a startup serving a local market and does not need large-scale funding, debt financing is probably your best, and perhaps only, option. More prominent startups often combine debt and equity financing to reduce the downside of both types.
Is debt financing good or bad for startups? ›
Raising debt is an important financial tool for startups, and in particular, as more and more companies become fintech companies, debt, and in particular asset-backed debt, can provide a critical vehicle for embedding financial products that can be financed – most commonly loans, but also insurance, credit cards, ...
Is debt funding good for startups? ›Venture debt can compliment venture capital and provide value to fast-growing companies and their investors. Unlike traditional bank lending, venture debt is available to startups and growth companies that do not have positive cash flows or significant assets to use as collateral.
What are the pros and cons of equity? ›- Advantage: No Repayment Requirement. ...
- Advantage: Lower Risk. ...
- Advantage: Bringing in Equity Partners. ...
- Disadvantage: Ownership Dilution. ...
- Disadvantage: Higher Cost. ...
- Disadvantage: Time and Effort.
| Source of finance | Advantages |
|---|---|
| Owners capital | quick and convenient doesn't require borrowing money no interest payments to make |
| Retained profits | quick and convenient easy access to the money no interest payments to make |
Well, the answer is that cost of debt is cheaper than cost of equity. As debt is less risky than equity, the required return needed to compensate the debt investors is less than the required return needed to compensate the equity investors.
What are the three main differences between debt and equity? ›| Debt Capital | Equity Capital |
|---|---|
| Definition | |
| Debt Capital is of three types: Term Loans Debentures Bonds | Equity Capital is of two types: Equity Shares Preference Shares |
| Risk of the Investor | |
| Debt Capital is a low-risk investment | Equity Capital is a high-risk investment |
The firm gets an income tax benefit on the interest component that is paid to lender. Therefore, the net taxable income of the company is reduced to the extent of the interest paid. All other sources do not provide any such benefit and hence,it is considered as a cheaper source of finance.
Which is higher cost of equity or debt? ›Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company's profit margins. Equity capital may come in the following forms: Common Stock: Companies sell common stock to shareholders to raise cash.
Why equity is more riskier than debt? ›It starts with the fact that equity is riskier than debt. Because a company typically has no legal obligation to pay dividends to common shareholders, those shareholders want a certain rate of return. Debt is much less risky for the investor because the firm is legally obligated to pay it.
Why debt financing is less risky than equity financing? ›Equity financing may be less risky than debt financing because you don't have a loan to repay or collateral at stake. Debt also requires regular repayments, which can hurt your company's cash flow and its ability to grow. You're a startup or not yet profitable.
What are the four basic factors that determine how a firm is financed? ›
the firm's economic potential, 2. the size and maturity of the company, 3. the nature of its assets, and 4. the personal preferences of the owners with respect to the trade-offs between debt and equity.
What is the key difference between debt and equity funding? ›What is the difference between debt and equity finance? With debt finance you're required to repay the money plus interest over a set period of time, typically in monthly instalments. Equity finance, on the other hand, carries no repayment obligation, so more money can be channelled into growing your business.
Which one is cheaper source of funds for a profitable company debt or equity? ›Debt is cheaper than equity for several reasons. However, the primary reason for this is that debt comes without tax. This means that when we choose debt financing, it lowers our income tax. It helps remove the interest accruable.
Why the cost of debt is different from the cost of equity? ›Cost of Equity is the rate of return expected by shareholders for their investment. Cost of Debt is the rate of return expected by bondholders for their investment. Cost of Equity does not pay interest, thus it is not tax deductible. Tax saving is available on Cost of Debt due to interest payments.
What is the disadvantage of equity financing? ›The main disadvantage to equity financing is that company owners must give up a portion of their ownership and dilute their control. If the company becomes profitable and successful in the future, a certain percentage of company profits must also be given to shareholders in the form of dividends.
Which is an advantage of equity financing over debt financing quizlet? ›Which is an advantage of equity financing over debt financing? It's possible to raise more money than a loan can usually provide.
Why can't startups finance debt? ›Equity investments and debt financing for startups
Most early-stage startups cannot borrow from traditional sources, such as banks and financial institutions, because they do not have a track record of cash flow or liquid assets to make required loan and interest payments.
As businesses mature, they become more attractive to traditional debt financing channels and lenders become more confident of their ability to repay debts. A mature business can depend on its proven creditworthiness and reputation to convince a bank of its ability to repay a loan.
What types of financing do small entrepreneurs typically use? ›Small business owners usually use either equity or debt financing. A pro to equity financing is that the owner can use personal assets rather than borrowing fund from outside sources, they can also sell shares of their company to investors.
What are the two benefits of debt financing? ›The amount you pay in interest is tax deductible, effectively reducing your net obligation. Easier planning. You know well in advance exactly how much principal and interest you will pay back each month. This makes it easier to budget and make financial plans.
What are the four types of debt financing? ›
...
Debt Financing can be funded by:
- Bank Loans.
- Bonds.
- Debentures.
- Bearer Bonds.
Debt Capital
Common types of debt are loans and credit. The benefit of debt financing is that it allows a business to leverage a small amount of money into a much larger sum, enabling more rapid growth than might otherwise be possible. In addition, payments on debt are generally tax-deductible.
The most common form of startup financing involves selling an ownership stake in the company in exchange for a capital contribution. These equity investments fall into one of two classifications: common stock or preferred stock.
What is startup debt funding? ›What is Venture Debt? Venture debt is a type of debt financing obtained by early stage companies and startups. This type of debt financing is typically used as a complementary method to equity financing. Venture debt can be provided by both banks specializing in venture lending and non-bank lenders.
In which type of fund there is no risk factor for the startup as no collateral is involved? ›| Characteristics of Investment | Equity Financing | Grants |
|---|---|---|
| Return to Investor | Capital growth for investors | No Return |
| Risk Factor | The risk factor for the investor is higher as he has no guarantee against his investment. | There is no risk factor for the startup as no collateral is involved. |
Here are the few disadvantages of having debtors in the business: Impact of Cash Flow: Having huge debt balances have a negative impact on the cash flows of the company as large amount is blocked with the debtors. Increased Risk: Higher debt means a higher risk of default.
Which is better equity financing or debt financing? ›In general, taking on debt financing is almost always a better move than giving away equity in your business. By giving away equity, you are giving up some—possibly all—control of your company. You're also complicating future decision-making by involving investors.
What is an advantage of using debt finance to help a business grow? ›What are the advantages of debt financing? The major advantages of debt financing are control, tax and predictability. One advantage of debt finance is that the debt is temporary.
What are the benefits of equity? ›The main benefit from an equity investment is the possibility to increase the value of the principal amount invested. This comes in the form of capital gains and dividends. An equity fund offers investors a diversified investment option typically for a minimum initial investment amount.
What are the advantages and disadvantages of debt financing of equity financing? ›Because equity financing is a greater risk to the investor than debt financing is to the lender, debt financing is often less costly than equity financing. The main disadvantage of debt financing is that interest must be paid to lenders, which means that the amount paid will exceed the amount borrowed.
What are the advantages and disadvantages of sources? ›
| Source | Disadvantage |
|---|---|
| Reference lists & bibliographies | Subjective selection by another Unclear criteria |
| Supervisors, colleagues, mentors | Bias Variability in willingness and motivation to help Priorities may be different May be large travelling distances Time pressure |
Advantages of self-financing your business:
Self-financing your business gives you much more control than other finance options. It also means that you don't need to pay back or rely on outside investors or lenders, who could decide to withdraw their support at any time.
Advantages of debt financing
Maintaining ownership – unlike equity financing, your business retains equity which means you continue to have complete control over your business. As the business owner, you do not have to answer to investors.
Consider equity financing if:
You want to avoid debt. Equity financing may be less risky than debt financing because you don't have a loan to repay or collateral at stake. Debt also requires regular repayments, which can hurt your company's cash flow and its ability to grow. You're a startup or not yet profitable.
According to the Corporate Finance Institute, equity financing is generally more expensive than debt financing. Why is debt cheaper than equity? Simply put, because equity carries a higher risk for investors.
Why is equity more expensive than debt financing? ›Equity capital reflects ownership while debt capital reflects an obligation. Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company's profit margins.
What are the benefits and drawbacks of debt financing? ›- You won't give up business ownership. ...
- There are tax deductions. ...
- Debt can fuel growth. ...
- Debt financing can save a small business big money. ...
- Long-term debt can eliminate reliance on expensive debt. ...
- You must repay the lender (even if your business goes bust) ...
- High rates. ...
- It impacts your credit rating.
The main disadvantage to equity financing is that company owners must give up a portion of their ownership and dilute their control. If the company becomes profitable and successful in the future, a certain percentage of company profits must also be given to shareholders in the form of dividends.
Which is cheaper debt or equity Why? ›Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders' expected returns are lower than those of equity investors (shareholders). The risk and potential returns of Debt are both lower.
Why cost of debt is always cheaper than cost of equity? ›Well, the answer is that cost of debt is cheaper than cost of equity. As debt is less risky than equity, the required return needed to compensate the debt investors is less than the required return needed to compensate the equity investors.
Why debt is cheaper source of finance? ›
The firm gets an income tax benefit on the interest component that is paid to lender. Therefore, the net taxable income of the company is reduced to the extent of the interest paid. All other sources do not provide any such benefit and hence,it is considered as a cheaper source of finance.
What are the three main differences between debt and equity? ›| Debt Capital | Equity Capital |
|---|---|
| Definition | |
| Debt Capital is of three types: Term Loans Debentures Bonds | Equity Capital is of two types: Equity Shares Preference Shares |
| Risk of the Investor | |
| Debt Capital is a low-risk investment | Equity Capital is a high-risk investment |
Debt involves borrowing money directly, whereas equity means selling a stake in your company in the hopes of securing financial backing. Both have pros and cons, and many businesses choose to use a combination of the two financing solutions.
What is the main difference between debt and equity financing? ›What is the difference between debt and equity finance? With debt finance you're required to repay the money plus interest over a set period of time, typically in monthly instalments. Equity finance, on the other hand, carries no repayment obligation, so more money can be channelled into growing your business.
What happens when a company has too much debt? ›A company is said to be overleveraged when it has too much debt, impeding its ability to make principal and interest payments and to cover operating expenses. Being overleveraged typically leads to a downward financial spiral resulting in the need to borrow more.
How do debt and equity differ in their costs and risks involved explain? ›The cost of equity is more than the cost of debt and it is a risky form of investment as the shareholders will only get returns if the company makes a profit, but in the case of debt, the lenders need to be paid a fixed rate of interest for loans.
Which source of finance has the highest cost of capital? ›Cost of equity is a return, a firm needs to pay to its equity shareholders to compensate the risk they undertake, by investing the amount in the firm. It is based on the expectation of the investors, hence this is the highest cost of capital.