The difference between equity financing and debt financing
/What is Equity Financing?
Equity financing is the process of raising capital by selling ownership shares in a company. Instead of taking on debt, businesses issue stocks or shares to investors in exchange for funding. This method is commonly used by startups, growing businesses, and publicly traded companies to finance operations, expansion, or acquisitions. The key features of equity financing are as follows:
No repayment obligation. There is no requirement to repay investors. Instead, they receive returns through dividends or capital appreciation if the company grows in value.
Ownership dilution. Since investors receive shares, existing owners' control over the company may decrease as more equity is issued.
Long-term capital. Equity financing provides long-term funding, making it ideal for companies that may not generate immediate profits to repay loans.
Higher risk for investors. Since returns depend on the company's performance, investors take on more risk compared to lenders in debt financing.
What is Debt Financing?
Debt financing involves borrowing cash from a lender. In return, the lender expects to receive periodic interest payments, as well as the return of the debt at the end of the loan period.
Comparing Equity Financing and Debt Financing
There are several differences between equity financing and debt financing, which are as follows:
Repayment obligation. Equity financing does not need to be paid back, while debt must be paid back in accordance with a repayment schedule.
Ownership interest. The investors who buy equity have just acquired an ownership interest in the firm, whereas the lender does not own such an interest.
Repayment obligation. The company is not obligated to make periodic payments to investors, though they may eventually demand a dividend; conversely, the lender will charge interest for the use of its funds.
Impact on income. The receipt of cash in exchange for stock has no direct impact on the firm’s taxable income, whereas interest expense is deductible from taxable income.
Impact on liquidity. The acquisition of equity funding improves the liquidity position of a business (since it now has more cash), while taking on more debt funding makes its liquidity position worse - it now has an obligation to pay back the money.