Debt or equity: Find out what’s best for financing a company

India’s 10-year bond yields flirt with 8%, highest in over 3 years Debt finance refers to the act of borrowing money from an external source with the promise of paying it back at a fixed date in the future along with a fixed rate of interest.

By Alok Mittal

Building a promising business venture is a lot like constructing a building. A blueprint has to be drafted based on current needs, allocations have to be made for future additions or expansions, and a strong foundation has to be then laid after assessment and elimination of potential loopholes – allowing the structure to gain height. But these desirable outcomes cannot be achieved if adequate funds are not available to the venture. Many promising business ventures have failed in the initial stages due to the unavailability of capital, just as many dazzling real estate projects have failed to reach completion due to the same reason.

All of this points towards one simple fact – funding and that too, funding of the right kind, is imperative to build a business as solid as the building it may be operating out of. Business have two popular sources to readily acquire capital from, namely debt finance and equity finance. But what are these two, how are they different from each other, and which one is more suited for your business? Let’s find out.

What is the difference between debt and equity finance?

Debt finance refers to the act of borrowing money from an external source with the promise of paying it back at a fixed date in the future along with a fixed rate of interest. There are many types of debt finance options available to businesses – including term loans, line of credit, invoice discounting, merchant cash advance, and so on. To understand the differences between debt and equity with greater clarity, let’s consider debt as an equivalent to tenure-based consumer loans that are sourced through a regular bank or an NBFC (Non-Banking Financial Company). For businesses, debt financing could either involve collateral (tangible security such as machinery, property, or any other equivalent) against the credit or be completely collateral-free as in the case of Mudra Yojna-based loans and specialized loan offerings extended by tech-driven digital lending platforms.

Equity finance, on the other hand, is a financial instrument that provides investment against a stake in the company. Equity finance doesn’t necessarily have a repayment cycle. The profits are reaped on the success of business, or business growth, via earned dividends or by exiting (selling the shares held within) the business venture. There is inherent uncertainty in timing of returns due to the uncertain nature in availability of exit options.

Equity financing offers a fair share of advantages to a company since it prevents risk accumulation and distributes the same amongst individual stakeholders. For instance, if your business sells 10 percent equity at a valuation of Rs. 1 crore (the projected growth of your business venture), then you’ve transferred 10 percent ownership of your firm to the investor for Rs 10 lakhs. Say if you experience losses post-investment, 10 percent of the overall losses accrue to the investor, thereby mitigating the impact of the loss on the founder/owner of the business.

Equity vs. Debt: So, which one is better for my business?

Different businesses have different financial conditions and requirements, wherein, either of the two could be an ideal match. Let us consider a scenario where you have two business ventures, Business Venture A and Business Venture B, both having equal net worth, equal valuations, and equal risk-reward ratio. Now, you decide to acquire equity finance for Business Venture A and debt finance for Business Venture B. If you experience losses and are not able to yield dividends, you will not be liable to make any payment for Business Venture A since the risk is also shared by the investor. However, you’ll have to make regular payments as per the prearranged loan repayment cycle for your Business Venture B. Failing to do so will result in a loan default.

The above illustration may make it seem like equity is what every business should opt for. But if we analyze both of the loan instruments vis-à-vis each other, you will find that debt financing (if available) is a more viable option for your business. This is because equity financing has multiple disadvantages.

First, it is not easily available due to the inherent risk. Investors, generally known as Angel Investors and Venture Capitalists, maximize their upside relative to risk by investing in high growth businesses. Tech-led start-ups are typical candidates for such financing, but this may not be the case for other entrepreneurs across different sectors and scale ambitions.

Debt also tends to be cheaper than equity in terms of expected returns. This is in line with the fact that debt is normally available for incremental improvements and growth of an existing business, whereas equity is targeted at higher growth and higher risk businesses.

Still, as the market reality stands to be, some business ventures cannot acquire debt financing due to prevalent constraints within banking institutions. Traditional lenders require collaterals, income tax returns amongst other documents which make a lot of MSMEs underserved. If it is so, you must explore the alternatives available within the burgeoning digital lending space where there are enough options available, including innovative loan instruments such as ‘debt against invoices’ and line of credit for your business. An added benefit is that your loan request gets approved within 24 hours of your loan application via some digital lending platforms. Always try and avail debt finance if it is available.

Alok Mittal is CEO & co-founder Indifi Technologies

Source: Financial Express