All businesses need some degree of funding in order to achieve long term operating objectives. One of the biggest decisions for a small business owner is whether to fund these long-term financial requirements through debt, equity, or a combination of both.
There are advantages and disadvantages to both forms of funding that should be considered when determining the optimal funding structure for a business.
One of the main sources of funding for a business is through equity. Equity funding can be raised in a number of ways, such as investment from the owners of the business, investment from family and friends, angel investors, venture capital investors, corporate investors or institutional investors.
Equity funding has several benefits. For example, the amount invested is not redeemable, there are no fixed repayment obligations and, profits can be maximised as there is no obligation to pay interest (which reduces the level of financial stress on cash flow). There is also no obligation for the business to pay dividends, which can be important during the start-up phase of a business where cash can be limited.
On the downside, the cost of equity funding is more expensive than debt funding. This is due to equity presenting a higher risk to investors because in the event of financial difficulty debt is repaid before equity. This results in a higher expected rate of return. Further to this, if dividend payments are made, they are not deductible for tax purposes.
Equity holders are also the last to receive repayment in the event of bankruptcy (hence the higher returns required).
Many businesses use some form of debt funding with commitment to payments of interest and/or principal at regular intervals. The main type of long term debt funding used by businesses is loans, either from a bank or other private investors. Larger businesses may also issue bonds.
The main advantage of debt funding is that it is generally a cheaper form of funding than equity and the interest payments are tax deductible.
The downside to debt financing is that interest payments must be made on a regular basis, which can put financial pressure on a business and impact on profitability. The regular outflow of cash also means less cash is available for other projects. In addition, if the business has too much debt, it may be viewed as high risk, and it may be difficult to obtain equity funding if required.
Most businesses opt for a mix of both debt and equity in order to try and reduce the downside of each type of funding. In some cases this can provide other advantages, for example it is possible to shift tax deductions for interest from a company to its shareholders by borrowing to acquire shares. Ultimately, the right mix will come down to the size of the business, appetite for risk, and the stage the business is at in its life cycle.