Equity vs. Debt: Cost of Equity vs. Cost of Debt
Aug 25, 2021
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 guide, 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.
Diving into the benefits and costs of debt financing
When considering debt versus equity, business owners must review the various types of available debt financing. The most common examples include:
- Traditional business loans, which are usually underwritten by a bank and have affordable interest rates but require good credit or a large number of assets for approval
- Loans backed by the federal Small Business Administration, which provide low rates and longer terms but also have stringent eligibility
- Business line of credit, which you can use as needed and has interest charged on your outstanding balance
- Business credit cards, which function just as personal cards and may offer rewards and other benefits
- Advancements on a portion of your debit and credit card sales
- Mezzanine or subordinate debt, in which a secondary lender bridges the gap between available financing and the company’s need for funds at a higher interest rate with a longer term and lower amortization
In addition to seeking traditional business loans, entrepreneurs can also sell business debt by issuing bonds to private investors. These individuals or businesses receive payment on a regular schedule with interest just as a bank or lender does when they write a business loan.
Before you take on business debt by taking on a loan or issuing bonds, it’s important to have a full picture of the pros and cons of this type of financing. These are the most common advantages identified by financial experts:
- Established loan terms that allow you to plan exactly how much you will pay each month, how much you will pay in interest and fees, and when you will finish repayment. Conversely, with equity financing, the investor will have a claim on your firm’s future profits.
- The ability to typically deduct interest on debt financing from your company’s taxable earnings.
- Complete separation from the daily operations of your business; unlike equity shareholders, who may expect input into how the company is run, lenders do not have the same power because they lack ownership of the business.
Fast funding after loan approval, usually within a few days to a few weeks.
On the other hand, business owners may decide to avoid debt financing where possible for these reasons:
- The risk for personal liability. If you become unable to pay the loan, the lender can potentially seize not only business assets but also your private assets.
- The difficulty of making sizable loan payments immediately when starting a new business venture. Repayment typically starts the month after receiving funds.
- The high cost of interest and fees. Taking on too much debt can prevent you from pursuing growth opportunities for your firm, another main difference between debt and equity financing.
Investigating the advantages and drawbacks of equity financing
When you raise money for your company with equity, you sell each shareholder an ownership stake in the firm in exchange for a capital investment. While we tend to think of large corporations that make initial public offerings of their stock on the public market when we hear the term “equity financing,” even small businesses can offer shares to interested parties in exchange for future profits in the firm.
Many businesses prefer equity vs. debt because it does not carry the upfront expense of interest repayment. Avoiding the financial obligation that comes with debt makes it easier to invest in the growth of the company but carries the expenses of sharing profits with your investors. The timing and form of repayment represent a key difference between equity and debt.
If your company cannot qualify for a business loan because of a lack of cash flow or collateral, you may be able to find an equity investor without these requirements. Instead, a prospective shareholder will look at your history of starting and growing successful businesses, the chance that this particular endeavor will succeed, and the projected long-term return of buying shares in a promising new venture.
Another difference between debt financing and equity financing? The latter 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 firm, 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 doesn’t transpire, you’ll need to start from scratch with another prospect.
If you decide to offer equity in your enterprise, research the applicable state and federal regulations in advance as part of your due diligence when weighing the difference between equity financing and debt financing. For example, depending on the size and structure of your company, along with other factors, you may need to get shareholder approval for certain business actions, hold regular shareholder meetings, and send frequent information to investors by mail.
Equity financing isn’t for everyone and may turn off entrepreneurs who want to maintain full control. However, even giving up just 10 percent of the company’s profits can provide the capital you need for impressive growth without ceding too much of your vision.
The bottom line: Cost of equity vs. cost of debt
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. Individuals and institutions that purchase a company’s equity shares have no guaranteed capital gains or dividend payments, limited claims to assets if the company goes bankrupt, and greater exposure to volatility than in the debt market. To compensate for these risks, investors expect higher rates and more benefits in return (a concept called the equity risk premium).
CFI recommends reviewing the cost of equity vs. cost of debt based on the weighted average cost of capital. This metric illustrates the cumulative cost of all the different types of capital held by a business, including both debt and equity. Use an online calculator to find the WACC of your business with the goal of keeping this number as low as possible.
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.