When a business needs money to maintain operations and expand their business, they often need outside sources of capital. But where do they get this capital from, and what is the right way to raise capital?
First off, let’s start with the two ways of raising capital: debt or equity. One is borrowing the money to be repaid at a later date, and the other is the sale of stock. Both bring in capital to a business, but both come with risks and downsides. Let’s look a little deeper.
Debt capital is going into debt, through borrowing money, with the intent to pay off that debt at a later date. This is typically done through either loans or credit. The advantage of debt is the opportunity to turn a small amount of money into a much larger sum of money through wise use of the capital, leveraging your debt to turn it into profit. This enables a company to grow at a pace that they otherwise might not be able to.
Another benefit of debt is that payments on debt are often tax-deductible. On the other hand, the downside is that no money is free, and you’re going to end up paying interest on the debt capital, meaning that you’ll end up owing more than what you received–and the payments need to be made no matter how well your company is doing. So the goal with debt is to take the debt capital and leverage it into an amount of profit that outweighs the interest–and to not take debt that you are unable to pay back.
Equity capital is raised by selling shares of stock in your company. The biggest benefit of equity capital is that there is nothing that needs to be repaid. You never have to make a payment to your shareholders to pay them for the stock (unless you’re purposely trying to buy it back). That said, there are downsides to equity capital.
For starters, a soon as you sell shares of your stock you own a little bit less of your company. The shareholders are co-owners now, and, the more stock you sell, the more the shareholders have power to make decisions about the way you run the company. Further, shareholders want the stock price to rise and for it to pay dividends, which means that you’re now in the position of needing to increase profits every quarter to keep the investors happy.
So, How Do You Choose Between Debt and Equity?
Generally, companies do a little of both (or a lot of both). The amount of money needed to obtain capital from different sources, the cost of capital, is essential in determining the right capital structure for your company.
Cost of capital can be expressed as either a percentage or a dollar amount: if you owe $10,000 at a 6% interest rate, then your cost of capital is either 6% or $600. (This does not take into account the tax-deductible nature of debt payments, which is sometimes accounted for in the cost of capital.)
Cost of equity is a little trickier to figure out and uses something called the capital asset pricing model (CAPM). The cost of equity reflects the percentage of each invested dollar that shareholders expect in returns.
The mix of cost of equity and cost of capital is together the capital structure, and to compare different capital structures accountants use the weighted average cost of capital (WACC).
The WACC multiples the two costs (capital and equity) and weights them according to the percentage of each. This WACC is what you need to know to make a proper decision about your debt and equity ratio.
Advantages of Debt Capital vs. Equity Capital
- With debt, you don’t lose any ownership in your company.
- >With equity, you don’t have to make any repayments.
- With debt, the lender only has claim on the amount of the loan and does not take a percentage of the future profits of the company. If the company is successful, it doesn’t have to pay more to the lender.
- With equity, you don’t have to pay interest, whereas with debt the interest rate is a fixed cost which raises the break-even point.
- With equity, you don’t have to worry about making loan payments with interest during economic downturns.
- >With debt, you can budget, forecast, and plan for future payments (except in the case of variable interest loans.)
- With debt, it is less complicated a process because you only have to deal with a lender and not state and federal securities laws and regulations.
- With equity, you’re not restricted by some loans that regulate what activities the company can engage in.