Growing a Business: Understanding Debt vs. Equity Financing

By Max Grinold

Businesses often have periods where they need an injection of capital to meet their goals for expansion. This could be buying a new factory, acquiring a manufacturer, increasing its workforce, expanding into another market, developing a new product, and much more. To secure this outside capital, businesses have two methods of financing: taking on debt or issuing equity. Each option has various advantages and disadvantages.

Advantages of Debt

No Ownership Dilution: When issuing debt, a company does not have to hand over a certain amount of ownership of the company. Rather than having an equity investor hold a small piece of the company profits, and possible governance rights, issuing debt can be an alternative way to raise capital without giving up any control or ownership stakes. This allows the existing shareholders to maintain full control over the company's decision-making and future direction.

Tax Benefit: Interest payments are accounted as an expense on a company's income statement, which lowers a company's taxable income. When a company's taxable income decreases, they have to pay less taxes overall.

Disadvantages of Debt

Repayment Obligations: Every debt issuance has an obligation to be repaid, in addition to interest expenses. This means that a company has to plan accordingly to guarantee that it will have the available capital on hand to repay the debt per its repayment schedule.

Increased Risk: Over-levering a company can create significant risks, including the possibility of bankruptcy. If a company takes on too much debt and is unable to meet its interest and repayment obligations, it may face financial distress. This can lead to a deterioration of the company's credit rating and potential increased costs of borrowing in the future. In extreme cases, if the company cannot generate enough cash flow to pay its debt, it may be forced to sell important assets or even declare bankruptcy.

Advantages of Equity

No Repayment Obligations: When issuing equity, there are no pre-defined repayment obligations to investors. While investors are expecting the financial success of your company, there is no fixed repayment requirement based on the ownership that they purchase.

Strategic Investor Involvement: Some investors are very active in helping guide a business to success, as they also have some skin in the game. Investors like these can often bring more than just capital to the table, as they offter valuable expertise, networks, and operational guidance that can accelerate growth. Their interest in the company's success aligns their personal goals with the underlying goals of the business, creating a productive relationship. 

Disadvantages of Equity

Ownership Dilution: The one major cost of equity is that you are diluting your ownership of the company. With outside investors owning a percentage of your company, you now have less governance rights and entitlement to your company’s income.

Dependence on Market Conditions: Raising equity could be very hard in a difficult market environment. During periods of economic uncertainty, some investors may have a reduced appetite for risk, preferring to invest in more secure assets rather than equity in a company.