Introduction to Corporate Financing
What are equity and debt financing?
Obtaining funding is a key part of establishing and running a business. Most business activities will require capital – for example, manufacturing the product. There are two main ways in which funds can be obtained – by issuing shares or obtaining loans.
Equity financing is the issuing of shares to investors to raise fund through sale of control rights in the company. Since shares represent control rights over the business, this financing method is fundamentally an exchange of ownership for capital inflow. The degree of control received by an investor will depend on the rights certificated in the shares that are purchased (please see our ‘Share structure and capital’ article). The dividend rights associated with shares can likewise be adjusted through class rights.
Debt financing, on the other hand, is the process of raising funds by borrowing from investors or financial institutions. This can be done through either a loan or bond issuance. Purchasers of bonds differ from investors who purchase shares because the contractual rights they receive bestow a limited or negligible role in the day-to-day running of the business. In contrast with equity financing, the money raised through debt financing does not become a permanent part of the business as it will ultimately have to be repaid, with interest.
Debt or equity financing?
Before opting for any financing method, there are a few considerations to be taken into account:
- Business structure
Only a company limited by shares can issue shares, so that neither a partnership nor a sole proprietorship have the option of equity financing. Further, there are two different types of company – a private limited company and a public limited company, and only the latter can offer shares to the public or list on a stock exchange. For more information on business structure please see our ‘Business forms’ article.
- Interest rate
The prevailing interest rate is likely to influence one’s choice – a higher interest rate will make debt financing more expensive, while a lower interest rate makes debt financing a more economical choice.
- Control and ownership
As stated above, equity financing involves the sale of ownership rights so that the investors will have influence over the overall operation of the business. If one wishes to remain in full control of the business, debt financing should be considered instead. This will also influence the type of shares a company issues.
- Ease of debt financing
This depends on various elements. Firstly, the financial condition of a business and its future outlook will determine a bank’s willingness to provide a loan. Further, the state of the economy and the lender’s overall position will also have certain weight on the bank’s willingness to loan. The same factors will affect the decisions of potential investors in bonds.
To know more about debt and equity financing, please see our detailed articles on the respective financing methods.
|Checklist – You should know: The basic methods of funding a business, namely equity financing and debt financing;The distinction between the two methods of funding; andThe relevant considerations when choosing the appropriate method of funding.|