Businesses need money to run or expand their current operations or to start a new business. To fund the requirements they mainly take two routes – equity financing and debt financing. Some businesses which are facing a fund shortage also resort to the commercial mortgage route to fund their requirements.
Equity financing – Equity financing involves raising the required capital in exchange for ownership interest in the business. This stake is offered in the form of shares and it can either be offered to the general public through public issue route or to private/institutional investors through the private placement route.
In case of private placement some/total transfer of management control is also involved and the amount of capital extended depends on the extent of control offered.
Debt Financing – When a business borrows money from an outside source and promises to return the money along with an agreed upon interest within a stipulated time, it is said to have taken a debt to finance its business needs.
Debt financing can take the shape of bonds, debentures, bills, or notes to be sold to individual and/or institutional investors. This can also take the shape of commercial loans raised from banks or other lenders.
Comparison between debt and equity financing
The main differences between these two options are related to the surrendering of the ownership stake and the amount of risk involved. In the case of debt financing while there is no surrendering of ownership stake, there is greater risk for the business in the event of non payment of the debt as business critical assets may be legally impounded by the lenders.
On the other hand, money raised through equity presents no such risk to the businesses but a partial/complete transfer of the ownership is involved.
One other small difference lies in the tax treatment of the payouts. While the interest portion of the repayment is deductible from tax liability, dividend payouts carry no such benefit.
In the case of small businesses, equity financing is usually not the viable option so they depend mainly on debt and lines of credit to keep the operations running.
Debt financing options
Fixed-Income Securities – A company seeking to raise money through the debt route offers securities carrying a certain amount of interest. These securities are redeemable after a certain period of time. People purchasing these securities, in essence, extend a loan to the issuing company.
Loans – Businesses borrow money from banks or private lenders. This kind of debt may or may not be backed by some sort of security also known as collateral. In case of the absence of any collateral, the loan is called an unsecured loan. Secured loans are also known as commercial mortgages.
Commercial mortgages – With commercial mortgages, a loan is extended against a business asset which is repayable over a period of time in the form of instalments. The instalments consist of a principal and interest portion. In case of non payment of instalments, lenders can seize and sell the asset to recoup the loaned amount.
While current market sentiments are not favourable to either, debt or equity financing route, commercial mortgages and commercial property loans are available quite easily to deserving businesses. By deserving we mean businesses which have strong fundamentals and a sound business plan. But to get the best deal one needs to get in touch with a number of lenders and the best way to do that is to approach a well networked broker firm.