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Why is debt financing better than giving up equity?

Debt Financing

In order to expand, it’s necessary for business owners to tap financial resources. Business owners can utilize a variety of financing resources, initially broken into two categories, debt, and equity. “Debt” involves borrowing money to be repaid, plus interest, while “equity” involves raising money by selling interests in the company.

What works better for the small and medium enterprise sector in India? An SME usually needs the funds during the stages of expansion or meeting working capital needs. In that instance, a company can either approach a bank for debt financing or a venture capitalist, private equity or angel investors for the funds.

But rather than equity funding why not take a loan? For one, loan processing is faster than raising equity capital and importantly there is no ownership dilution. In early stages of a business, it may be better for an entrepreneur to raise debt and look for equity after the business has stabilized. This can help them negotiate better terms.

Now let’s talk about debt financing and equity in broader terms.

Debt financing is borrowing funds from an outside source with the commitment to repay, plus interest. This encompasses traditional loans, such as those offered by banks. Borrowers make payments monthly and offer a form of collateral, such as inventory, real estate, accounts receivable, insurance policies or equipment, which can be used to repay the loan if the borrower defaults on the loan.

Equity financing involves funding business aspirations by selling individual shares of the company to investors. Business owners who choose this method don’t have to repay the money in regular installments. Instead, those individuals who purchased shares of the company become partial owners who are entitled to a portion of the profits for as long as they hold those shares.

The advantages of debt financing are numerous. First, the lender has no control over your business. Once you pay the loan back, your relationship with the financier ends. Next, the interest you pay is tax deductible. Finally, it is easy to forecast expenses because loan payments do not fluctuate.
Debt financing is available in some form for most small business owners. It is most popular with traditional business, such as those companies in the manufacturing or retail sectors. With traditional debt financing, borrowers retain complete control of their business, and they have a finite agreement with their lender.

Also Read: How To Finance the Growth of A Business?

Advantages of Debt Compared to Equity

  • Because the lender does not have a claim to equity in the business, debt does not dilute the owner’s ownership interest in the company.
  • A lender is entitled only to repayment of the agreed-upon principal of the loan plus interest and has no direct claim on future profits of the business. If the company is successful, the owners reap a larger portion of the rewards than they would if they had sold stock in the company to investors in order to finance the growth.
  • Except in the case of variable rate loans, principal and interest obligations are known amounts which can be forecasted and planned for.
  • Interest on the debt can be deducted from the company’s tax return, lowering the actual cost of the loan to the company.
  • Raising debt capital is less complicated because the company is not required to comply with governmental laws and regulations.
  • The company is not required to send periodic mailings to large numbers of investors, hold periodic meetings of shareholders, and seek the vote of shareholders before taking certain actions.

 

Of course, sometimes giving up equity can have better benefits than borrowing a loan. Equity financing allows the business owner to distribute the financial risk among a larger group of people. When you aren’t making a profit, you don’t have to make repayments. And if the business fails, none of the money needs to be repaid.This type of funding is well suited for start-ups in the innovation or technology sectors; it requires a strong personal network or an appealing business plan. However, it doesn’t put constraints on cash flow and isn’t as financially risky as other options.

For example, if you run a small business and need ₹40,000 of financing, you can either take out a ₹40,000 bank loan at a 10 percent interest rate or you can sell a 25 percent stake in your business to a private equity for ₹40,000.

Suppose your business earns a ₹20,000 profit during the next year. If you took the bank loan, your interest expense (cost of debt financing) would be ₹4,000, leaving you with ₹16,000 in profit.

Conversely, had you used equity financing, you would have zero debt (and as a result, no interest expense), but would keep only 75 percent of your profit (the other 25 percent is owned by the private equity). Therefore, your personal profit would only be ₹15,000, or (75% x ₹20,000).

From the example, you can see how it is less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity. Taxes make the situation even better if you had debt since interest expense is deducted from earnings before income taxes are levied, thus acting as a tax shield.

How can we (FlexiLoans) help you?

Now that you’ve read how debt is better than equity, and how taking a small loan for your business might actually be beneficial for you, you might be wondering ‘where can I get my business a loan with a good interest rate and a hassle-free loan?’ Well, that is when we come into the picture. FlexiLoans is an online lending platform built to reduce the vacuum between the borrower and a loan especially in the SME space. With technology growing rapidly in this environment we’re aiming to capitalize on borrowers looking for collateral-free loans with no credit history. We believe in providing the best solution for your business at your convenience.  Click on this link to apply now.

 


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