Part of having a successful company is dependent on growth, and quite often, attaining that type of growth takes money. Expansion in any form, whether it’s acquiring the assets of another company, getting new facilities or equipment, or simply needing capital for more inventory to convert to future sales growth, rarely occurs without infusing some cash into the company.
There are a few ways to raise capital, including finding an angel investor; borrowing money (commonly referred to as debt financing) or issuing shares (publicly or privately) in the company (equity financing) are some of the most common ways. When performing due diligence in anticipation for an M&A (merger and acquisition), it is an important way to assess the fiscal health of both your company and the target company. Here, we’ll discuss debt financing versus equity financing and go through the pros and cons of both.
What Is Debt Capital?
Like the name says, debt capital is just that — raising capital by going into debt, which is a fancy way of saying “borrowing money.” Of course, the act of borrowing money requires repayment, which is part of the terms of the financial agreement. The main advantage of debt capital is that it enables your company to leverage the borrowed money to grow at a faster rate. And in some cases, the interest payments are tax deductible.
Of course, debt capital has disadvantages as well. The main one is obvious — since you’re paying interest on the outstanding debt, this means that you’re paying back more than you initially borrowed from the lender, which is the case in any loan you secure.
What Is Equity Capital?
Equity capital is the money a company receives from investors. In exchange for this investment, the company issues stock — either common stock or preferred stock. The money these investors paid would be returned to them if the company’s assets were liquidated and all outstanding debts were repaid. As far as the number crunching goes, this is listed on the books as “shareholder equity,” and it is commonly viewed as a barometer of a company’s financial health.
The formula and calculation for shareholder equity is a simple one, as the following equation shows.:
Shareholders’ equity = Total assets – Total liabilities.
One of the biggest advantages of equity capital is that the capital gained is not a loan, therefore nothing must be paid back to the investors.
Of course, this arrangement raises some additional issues. Because you have sold shares of your company to outsiders, this technically makes them “part owners” of the company and you own a little bit (or a lot) less than you did before you issued stock. Because they’re now part owners, they will want the company to be increasingly profitable and will have strong opinions on matters (mainly financial, but other issues as well) about decisions the company makes.
Debt Financing vs. Equity Financing
There is no hard and fast rule about which process is the right one for your company, as every situation has its own set of unique circumstances. However, the cost of debt equity is far easier to assess; the terms of the loan are spelled out in the paperwork.
Figuring out the cost of raising equity capital? Not nearly as easy. There are a lot of acronyms that help calculate this, including CAPM (capital asset pricing model), which indicates what percentage of investment is reflected in shareholder returns. There is also WACC (weighted average cost of capital), which weighs the two costs (equity and capital) according to the percentage of each.
There are differences that only your company will be able to make when you weigh the pros and cons of debt capital versus equity capital.
The following list includes some debt capital pros:
- You retain 100% ownership in the company.
- The lender only has financial interest in money owed and none in future profits.
- You have the ability to forecast payments.
The following list includes some debt capital cons:
- Payments must be made no matter what the financial status of your company is.
- There is a cost to borrowing money.
- Collateral is sometimes required to secure a loan.
The following list includes some equity capital pros:
- You aren’t required to repay a loan.
- No debt is on the books.
- No interest is paid to the lender.
The following list includes some equity capital cons:
- Ownership in your company is diluted.
- You must comply with industry regulations.
- There are more points of contact to deal with as opposed to one lender.
The Final Piece: Securing a VDR
One vital component of any M&A process is securing a trusted and reputable virtual data room (VDR) provider. A VDR is a secure online vault for the storage and sharing of documents involved in the transaction, and is an important part of the process, as its dashboard allows admins to control access privileges for the financial and legal professionals as well as the other parties who are involved in the process.
Caplinked, an industry leader in the VDR space, provides secure online workspaces that are secure yet simple to manage. To see how robust its secure VDR is, sign up for a free trial that will allow you to see its management features, document collaboration controls, customizable permissions and more.
Chris Capelle is a technology expert, writer and instructor. For over 25 years, he has worked in the publishing, advertising and consumer products industries.
The Balance Small Business – Debt Financing Pros and Cons
Investopedia – What are Different Ways Corporations Can Raise Capital
Bloomberg | Quint – What is Equity Capital