While most entrepreneurs dream of having a successful company, a growing business often comes with its own unique set of problems.
One of the most common challenges an expanding enterprise faces is how to obtain the capital it needs to continue to evolve and prosper.
For a growing business, the two most common financing options are equity capital and debt capital. “In its simplest form, equity capital involves raising money by selling interests in the company,” explains Kenny Moore, executive vice president, specialty lending at BBVA Compass. “While debt involves borrowing money to be repaid plus interest.”
Anyone who has ever gotten a mortgage for a home or a loan for a car is familiar with debt financing. If a company wants to rely on debt capital to secure funds to invest in the business, it will need to borrow from a financial lender like a bank. The transaction is relatively straightforward with formalized lending terms and a set interest rate over an ascribed time period. Depending on the size and credit history of the company, there is usually some flexibility regarding the interest and the repayment length.
On the other hand, if an organization chooses to rely on equity capital rather than go to a bank for funds, it turns to investors for financing. To raise capital, a company will sell shares (i.e. its equity) in the business to a group of investors known as shareholders. In exchange for their money, shareholders get a stake in the future of the company, and the stock’s value is directly related to the company’s financial ups and downs.
Pros and cons of debt capital
Equity and debt capital each have their own positives and negatives. In terms of debt capital, paying interest over a long period of time can be onerous, especially for a smaller business that may not have the clout to negotiate favorable interest rates.
The interest rate (also known as the cost of capital) can add up to a significant amount over the course of several years and thus infringe on the profits and growth of the company to some degree. Additionally, in order to secure the loan, the company may be required to provide assets as collateral, which can significantly increase risks if a business can’t make its loan payments.
But there are notable benefits. “Debt does not dilute the owner’s interest in the company,” says Moore, who also points out that “interest on the debt can be deducted on the company’s tax return.”
Because interest is a known quantity, the organization can at least plan for the expense and find ways to offset to some degree the drain interest payments can put on the company’s growth capital.
Pros and cons of equity capital
With equity capital, the business doesn’t have the ongoing burden of using a portion of profits to make large interest payments and therefore it has more capital to spend on expanding the business. The lack of debt, however, comes at the cost of flexibility and control. By selling stock in a company, business owners are relinquishing a portion of their ownership and potentially control over their own enterprise.
Fortunately, there are ways to offset the risks of equity capital, says Moore. “The owner can sell a minority portion of stock (less than 50 percent) which allows them to retain control. In some situations where the owner sells more than 50%, they can negotiate super-voting right controls, which allows them to maintain decision-making control even if they no longer maintain economic control.”
Of course, having investors who can influence your business isn’t necessarily a bad thing. New investors can bring new ideas and a larger pool of expertise to help steer the company in new and possibly more profitable directions.
Deciding between equity versus debt capital comes down to a careful analysis of the unique needs and strengths of your business, so enlist the help of trusted and well-qualified advisers to determine the best path.