Pile of Coins


Gregory S. DuPont Jan. 25, 2019

Should you use debt (borrowed funds), equity (capital that does not need to be repaid), or a combination of the two to raise capital for your business? Whether your business is a start-up or established, these financing decisions will directly affect the potential growth and profitability of your business.

Debt Financing
Like many business owners, you may favor debt financing because creditors and lenders have no direct claim on the future earnings or value of your company. Your obligation to creditors ends when you repay the debt. Another benefit of debt financing is that in some cases, interest paid on loans may be deducted on your company’s tax return, lowering your real cost of capital. Be sure to consult a qualified tax professional for up-to-date Internal Revenue Service (IRS) rules regarding interest paid on loans before choosing debt financing as an option.

Despite some advantages, debt can put a considerable strain on your business, especially if cash flow is weak. Regardless of your business’s financial position, both principal and interest must be repaid in a timely manner, and usually within a relatively short time period. In addition, interest is a fixed cost that will increase your company’s “break even” point. If your business experiences financial problems, debt can drastically affect profitability.

Although your obligation to the creditor ends when you repay a loan, the creditor may include restrictive covenants (e.g., restrictions on capital expenditures) as a contingency for granting the loan. These covenants may severely limit your control over business operations.

Equity Financing
Equity financing provides capital that does not need to be repaid, making it particularly attractive to businesses without enough cash flow to service debt. In addition, equity financing has no fixed cost. Equity financing, however, can significantly dilute your ownership interest and may diminish your operating control. Due to these risks, an equity provider may request a position of authority within the company, such as a seat on your board of directors. If your business is well established, this request may be an infringement. If your business is new, you may benefit from the investor’s knowledge.

The real cost of equity financing is often greater than debt financing for two reasons: 1) due to generally higher risks, investors may require greater returns on investment than creditors; and 2) dividends are not tax deductible, therefore leading investors to expect sizable capital gains from business growth.

Debt/Equity Combinations
When weighing the advantages and disadvantages of debt versus equity, you may discover that neither straight debt nor straight equity adequately meets the capital needs of your business. Therefore, you may want to consider a combination of debt/equity. One option is to couple debt with equity additions, which are warrants that enable investors to purchase a portion of your company’s stock at a fixed price sometime in the future. Such an arrangement may improve your chances of securing financing because investor risks are reduced and returns are increased. This method will also minimize debt service and limit the amount of equity you must relinquish.

Finding the Right Ratio
What is the correct debt-to-equity ratio for your business? There is no right or wrong answer to this question. However, if your business has an abnormally high debt-to-equity ratio, there is some risk that your debt instruments may be re-characterized as equity for tax purposes. Also, potential investors or lenders reviewing your company’s financial statements will look for a debt/equity ratio consistent with the industry average for your particular business.

If your business currently has a high debt-to-equity ratio compared to others in your industry, you may want to consider seeking equity financing. Lending institutions usually avoid highly leveraged companies for fear these companies will have difficulty meeting interest and principal payments. If your business has a low debt-to-equity ratio, consider pursuing debt financing. Lenders view highly capitalized businesses as stable, and consequently, may be more willing to make favorable loans.

The amount of debt or equity your business is currently carrying should not be the only factor affecting your financing decisions. In addition to ratios, stability of cash flow can affect business continuity and should also be examined. A careful analysis of your current situation can help you determine the type of financing that will best meet your needs.