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Debt Financing Versus Equity Financing

Growing a business requires money. Growth can be financed by borrowing money from a bank or financial institution, or by selling shares in the value of the business. Many business owners wonder which method is better. The answer is that it depends.

Generally, debt financing carries several advantages over equity financing. To start, debt financing will not dilute the ownership interests in the business. The business is only required to repay the amount borrowed plus agreed interest and fees. If the growth effort is successful, the owners of the business will realize greater return than if they had chosen to sell equity interests to investors to finance the growth. Similarly, principal and interest obligations are known amounts that the business can use to forecast operating costs and breakeven points as time passes.

Interest on the debt is often tax-deductible as well, allowing the business to write-off the primary cost of borrowing. Raising money through debt financing also avoids the effort and expense of complying with securities laws, a necessary burden of equity financing. Despite these advantages, not all businesses will be able to secure the amount of capital they need to grow the business through debt financing. Businesses that are relatively new or lack credit may find it impossible to secure large loans from a bank or financial institution. In these scenarios, equity financing might be the only available option.

However, equity financing does have a few benefits of its own. Servicing debt raises the operating costs of the business, and making it marginally more difficult to generate a net profit. Equity does not add any similar fixed costs, and paves a smoother path to profitability in this regard. Additionally, cash flow will be negatively impacted by the periodic principal and interest payments. The lender will not make exceptions for the ebbs and flows of the business cycle. This can create short-term working capital challenges for the business.

Debt notes are often secured against some assets of the company, in order to ensure that the lender ultimately gets paid. The financing agreement might name the receivables, inventory, or physical equipment of the business. The agreement will probably also place restrictions on the activities the company may pursue, constraining management from pursuing additional money-raising activities or creative business opportunities outside the core activities of the company. The agreement might place even heavier burdens on the owners.

One of the most agonizing decisions a business owner may ever face is whether to accept loan terms that require a personal guarantee on the loan. Agreeing to such terms means that the personal assets of the owner are exposed and used as collateral. As with the debt versus equity financing question, there is no universal answer to whether this is the right choice; each business owner must consider the circumstances to decide whether the risk is worth accepting.

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