Having enough funds to expand business operations or change capital structure are challenges that many companies in the middle market and lower middle market face. In general there are two options: raise equity or raise debt. Weighing the positives and negatives of both is crucial to decide which method is most suitable. Oftentimes, businesses choose to have a healthy mixture of both.
Equity financing is a solution that doesn’t require repayment, but comes with some significant strings attached. Companies give up the ability to have unilateral decision making, and are forced to give up a portion of the company. Equity is often pursued by younger companies that have less proven business models or by companies in sectors that have historically unpredictable cash flows. Companies that have few tangible assets generally choose to finance through equity since they do not have physical collateral.
Advantages to Equity:
- Does not need to be paid back, and is therefore a good option if you cannot afford to make regular payments on debt
- Having access to your investor’s network can help your business and establish legitimacy
- Many investors will not expect an immediate return on their investment
- Profits do not need to be diverted to repay a loan
- No requirement to pay back the investment if the business is not successful
- More cash on hand
Disadvantages to Equity:
- Involves legal, accounting, and other financial services fees
- Investors will want to be relatively involved in the business decision making process and informed about any proceedings
- Can result in one party or another eventually being bought out of the business if differences are irreconcilable
- In the earlier stages of a company, more ownership will need to be sold to reach a certain level of financing
Debt financing provides companies with capital and requires no loss in ownership, and the decision making power stays in the business. However, the repayments required can sometimes restrict flexibility. Debt financing is often chosen by companies that have proven business models and stable cash flows, or by companies in industries that have predictable cash flows. Businesses that have large amounts of physical assets may also choose to use this type of financing since it is easy for them to provide collateral for a loan.
Advantages to Debt:
- The lender has minimal influence on the way the business is operated or ownership in the business
- Interest is tax deductible
- Short-term or long-term debt can be used as needed by the business
- Business relationship between the lender and company ends when the loan is repaid
- If interest rate is fixed, principal and interest payments are known amounts that can be budgeted for accordingly
Disadvantages to Debt:
- The loan must be repaid within a fixed amount of time
- If the company takes on too much debt, cash flow problems could lead to bankruptcy
- Too much debt can make the business riskier – and less enticing to equity investors in the future
- Debt financing can weigh down the company during hard times
- Assets of the business are held as collateral if the loan is secured
CrowdOut’s platform allows mid-sized companies in various industries to explore debt financing options with fewer fees and faster funding than traditional lenders. The CrowdOut blog will continue to provide information on different types of financing, financial trends, and how CrowdOut can help companies and individuals meet their financial needs.