Small or large businesses are the backbone of any economy, and with the ripple effect of Covid-19 on economies all over the world, there has been multiple shocks on the global economy which continue to reverberate worldwide.
The Ukraine-Russia war has its cost on the global economy, disrupting food and energy markets and exacerbating food insecurity and malnutrition in many countries. There is an evident surge in energy prices that has weakened household spending and undermined business confidence. The conflict has dislocated supply chains, caused shortages of food and other essentials and shaken markets across the globe.
Climate crisis has had another share of economic damage. The economic response to climate change will require spending across the public and private sectors in all countries of the world. Companies are increasingly closing doors or struggling to maintain healthy profit margins, hence the increased needs in company financing. Company financing may raise an issue as to which type of financing a company may opt for between equity, debt.
Debt financing or equity financing: is debt cheaper than equity?
Understanding the foundational business concept of equity vs. debt is essential for investment success. While both equity and debt allow business owners to acquire financing, equity involves selling interests in the company, while debt is the practice of borrowing money and repaying that amount plus interest. In this article, we explore the advantages and potential drawbacks of both equity and debt financing so you can make an informed decision when raising capital for your enterprise.
Companies always look for the cheapest possible financing. Debt financing is therefore considered the most cost-effective form of financing because of its unique tax benefits; indeed, interest paid on debt is tax-deductible. Moreover, the lender has (in principle and practically) no control over the business of the borrower. However, this type of financing is somewhat expensive, continuously elusive, and risky. Debt has a real cost to it: periodical interests; a default will lead to, worst case scenario, liquidation of the company. Besides, given the interest rate on business loans, this traditional way of financing seems inaccessible and prohibitively expensive for companies with low cash flow, often considered high-risk investments by lenders.
On the other hand, with equity financing, equity investors bring onboard money and expertise. Indeed, in addition to funds brought in by the new investor, the company may benefit from his/her/its experience, skills and connections. Furthermore, equity financing does not exert additional burden on the company, and since there is no repayment obligation, when the business incurs losses, equity financing costs nothing.
The drawback of equity financing however should not be ignored, especially when it comes to its cost, the control over the company and profit sharing. Equity financing requires you to devote a significant amount of time to finding and negotiating with the right potential shareholders. If you decide to raise money by offering shares in your company, you must reach an agreement that satisfies both parties in terms of percentage ownership and cost.
The process also involves a projection of the value of your business, which may require a professional business broker or investment bank as a middleman. If a deal does not transpire, you will need to start from scratch with another prospect. Equity financing dilutes control over the company and the only way to get rid of a difficult investor may be to buy him/her/it out, which might be more expensive than onboarding him/her/it, not to mention the non-quantifiable losses in broken relationships, reputational damage to the company and the risks of inside proprietary information on the loose and the risk of weaponizing it against the company.
In the end, however, the decision about whether equity financing or debt financing for your business must go beyond cost to the crux of your mission and objectives. Could you benefit from an equity investor who can serve an advisory role in your business as it grows? Are you seeking a potential partner, or do you prefer the lean approach of keeping costs down with debt rather than equity?
As you think about the answers to these questions and consider the pros and cons of debt and equity, strive to create a balance that works for your business goals.
Distelle Nana Mbeuyo is a lawyer at Fountain Advocates, a specialised law firm in Kigali