Question

Small business owners face important financing issues in deciding how to best fund their company.   When they reach a point where they qualify for debt financing, they still have a number of decisions as to acquire either debt or equity financing. Discuss the pros and cons of each (minimum five on each side).

Answer 1

Advantages of Equity

• Less risk: You have less risk with equity financing because you don't have any fixed monthly loan payments to make. This can be particularly helpful with start-up businesses that may not have positive cash flows during the early months.
• Credit problems: If you have credit problems, equity financing may be the only choice for funds to finance growth. Even if debt financing is offered, the interest rate may be too high and the payments too steep to be acceptable.
• Cash flow: Equity financing does not take funds out of the business. Debt loan repayments take funds out of the company's cash flow, reducing the money needed to finance growth.
• Long-term planning: Equity investors do not expect to receive an immediate return on their investment. They have a long-term view and also face the possibility of losing their money if the business fails.
• No obligatory dividend payments: Equity finance for a new company is like blessings of an angel. Equity mode of finance gives management a breathing space by having no fixed obligation to pay dividends. A company can choose to pay no dividend or smaller dividends as per the cash flow position.

Disadvantages of Equity

• Cost: Equity investors expect to receive a return on their money. The business owner must be willing to share some of the company's profit with his equity partners. The amount of money paid to the partners could be higher than the interest rates on debt financing.
• Loss of Control: The owner has to give up some control of his company when he takes on additional investors. Equity partners want to have a voice in making the decisions of the business, especially the big decisions.
• Potential for Conflict: All the partners will not always agree when making decisions. These conflicts can erupt from different visions for the company and disagreements on management styles. An owner must be willing to deal with these differences of opinions.
• No tax shield: The dividends distributed to the shareholders are not a tax-deductible expense. On the contrary, the interest expense is an eligible expense for tax benefits.
• No benefit of leverage: Debt funding has an indirect benefit available to the existing owners. Since a project with the higher rate of return (12%) than the cost of debt funds (8%) would enhance the welfare of the shareholders. It is because the margin of 4% will be distributed to the existing shareholders. If the project was financed by equity, this additional benefit would not have occurred to the existing shareholders but would equally distribute between old and new shareholders.

Advantages of Debt

• Control: Taking out a loan is temporary. The relationship ends when the debt is repaid. The lender does not have any say in how the owner runs his business.
• Taxes: Loan interest is tax deductible, whereas dividends paid to shareholders are not.
• Predictability: Principal and interest payments are stated in advance, so it is easier to work these into the company's cash flow. Loans can be short, medium or long term.
• Lower interest rate: Analyze the impact of tax deductions on the bank interest rate. If the bank is charging you 10% for your loan and the government taxes you at 30%, there's an advantage to taking a loan you can deduct.
• Company is not required to send periodic mails: 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.

Disadvantages of Debt

• Qualification: The Company and the owner must have acceptable credit ratings to qualify.
• Fixed payments: Principal and interest payments must be made on specified dates without fail. Businesses that have unpredictable cash flows might have difficulties making loan payments. Declines in sales can create serious problems in meeting loan payment dates.
• Cash flow: Taking on too much debt makes the business more likely to have problems meeting loan payments if cash flow declines. Investors will also see the company as a higher risk and be reluctant to make additional equity investments.
• Collateral: Lenders will typically demand that certain assets of the company be held as collateral, and the owner is often required to guarantee the loan personally.
• High rates: Even after calculating the discounted interest rate from your tax deductions, you might still be faced with a high-interest rate because these will vary with macroeconomic conditions, your history with the banks, your business credit rating and your personal credit history.
• Impacts on your credit rating: It might seem attractive to keep bringing on debt when your firm needs money, a practice knowing as “levering up,” but each loan will be noted on your credit report and will affect your credit rating. The more you borrow, the higher the risk becomes to the lender so you'll pay a higher interest rate on each subsequent loan.