Corporate Debt Versus Equity
Financing a business, speaking generally, takes two general approaches: debt, or loans from banks or other institutions, and equity, or selling shares to raise funds. There are benefits and problems with both, and it is more than likely that a new business should mix the two forms of financing to take advantage of their respective benefits and balance out their respective problems.
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Features
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Debt financing is simple: it is the taking out of a loan from a bank, credit union or other financial institution. In general, you have to have good credit, a solid business plan, the promise of investors and collateral to take out a loan and the risks are often high. Equity financing refers to the raising of capital through selling shares, or chunks, of the business to investors looking for capital gains and/or dividends. Equity financing turns the business into a collective enterprise made up of its main investors who then take the reins of the business in exchange for cash.
Benefits (Debt)
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The main set of benefits of debt financing center around control. Debt financing is an individual relation between a business owner and a bank, not a set of investors. You, in theory, retain full control over the business and do not have to share profits with anyone. In addition, interest on debt repayment is tax deductible.
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Benefits (Equity)
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Selling shares in your firm raises cash that does not have to be paid back directly. If the business is having cash flow problems, then selling shares might be the only viable way to raise funds. Having investors means the risks of the venture are spread out among a circle of investors, and these investors might have some good ideas on how to improve the functioning of the business.
Problems (Debt)
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Too much debt can cut into profits and hurt your credit score. The more debt a firm carries, the more it must pay out in monthly payments to banks or other bondholders. For firms under financial pressure, debt means more obligations on the part of the business. In addition, banks might insist on greater control over the business and may add conditions to your functioning as owner. While this depends on the specific situation, a bank may wrest some limited control over the firm no differently than a private investor.
Problems (Equity)
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As the risks of any business are shared with investors when equity financing predominates, the profits too must be shared. Control is taken out of the hands of the owner and given to a board of directors who control the general policy and oversight of the firm.
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