Running a business whether a company or Small and Medium Enterprises (SME's) can be financially demanding. Where this is the case, business owners seek various options to fund the business. The options available include debt financing and equity financing. Nevertheless, these options have their pros and cons which will be looked at in this article.
Debt Financing
Debt financing involves borrowing money and paying back with interest.1 Money lenders include banks, financial institutions, or bondholders. The borrowed funds must be repaid with interest over a specified period. Debt financing can be done through loans, bonds, or other financial instruments. Debt financing could either be a secured debt or unsecured debt. A secured debt is a debt on which payment is guaranteed by an asset or a lien which is usually a collateral such as a mortgage.2 This stands in contrast to unsecured debts that do not require collateral.
A simple illustration of debt financing is where a financial institution gives a business owner a sum of money in advance which could either be secured by a collateral or not, and the business owner agrees to repay it either in full or by installments, usually with interest over a certain period of time. The terms will specify the repayment schedule and interest rate.
Implications of Debt Financing
- Ownership Retention: One of the major advantages of debt financing is that it does not reduce ownership or require giving up of ownership of the business. The business owner retains full ownership and control of your business. The lender does not get a say on how you run your company. The original shareholders maintain control over the company because lenders do not gain any ownership stake or influence corporate decisions on the company or business.
- Repayment Obligations: Debt must be repaid regardless of the company's financial situation. The company must repay with interest on a fixed date. This can put a strain on the company's cash flow3 because regular repayments are required. Failure to meet the scheduled date for repayment and other obligations required can lead to default and potentially severe consequences, including bankruptcy.
- Interest Costs: The cost of debt includes not just the repayment of the principal but also interest payments. Over time, these interest payments can accumulate and become too overwhelming to pay.
- Financial Flexibility: Debts managed properly can increase returns on equity. Where a company generates returns that surpasses the cost of debt, it can lead to higher profitability and improved returns for shareholders.
Equity Financing
Equity financing involves giving up a share of ownership to investors. Investors who provide equity financing receive ownership stakes in the company and also a say in its operations, which gives them some level of influence over decisions made on the business. Although, this depends on the class of shares they hold.
Equity could be seen where a company offers its shares to investors. They provide capital in exchange for a share of ownership and potential future profits. Unlike debt, the company is not obligated to repay the money.
Implications of Equity Financing
- Ownership Reduction: Selling equity means giving up a portion of ownership and control. Issuing new shares reduces the ownership of existing shareholders. This can lead to a reduction and influence for the original owners and can affect decision-making power and distribution of profits within the company.
- No Repayment Obligation: The company does not need to make regular payments or worry about repaying the capital. Unlike debt financing, equity financing does not require repayment, returns come via dividends or profit sharing.
- Cost of Equity: The cost of equity is often higher than debt because investors require a return on their investment in the form of dividends or profit sharing. This higher cost can be more expensive in the long run compared to debt financing.
- Increased Scrutiny and Reporting: Equity investors typically expect detailed financial reporting and governance. This scrutiny can lead to increased administrative costs and a greater emphasis on corporate governance practices.
- Long Term Growth: Equity financing can provide the capital necessary for growth and expansion without the pressure of regular repayments. It can also align the interests of investors with those of the company's long-term success. Investors might bring additional benefits such as strategic advice, connections, and credibility, which can help the business grow.
CONCLUSION
Both debt and equity financing are to an extent beneficial to business growth notwithstanding the fact that they are not void of having a negative effect on businesses. Hence, it is paramount that business owners understand these implications when making informed decisions that align with their financial plans and long-term goals.
Footnotes
1. J.B. Maverick, 'Equity Financing vs. Debt Financing: What's the Difference?' (Investopedia, 13 June 2024)https://www.investopedia.com/ask/answers/042215/what-are-benefits-company-using-equity-financing-vs-debt-financing.asp accessed 15 May 2025.
2. Abu-Al-Qasim Ltd & Anor v. FBN. (2021) LPELR-54538(CA).
3. M & T Bank, 'Debt Financing vs. Equity Financing' (M & T Bank) https://www.mtb.com/business/business-education-portal/how-to-finance-your-small-business/debt-financing-vs-equity-financing-options#:~:text=Debt%20financing%20refers%20to%20taking,depend%20on%20your%20individual%20situation. accessed 15 May 2025.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
