The following outlines the major reasons why businesses may choose to use debt financing over issuing equity when capital is needed.
Businessesandother entitiescanfinance theirenterprisesbyissuing equity orusingdebt, such asborrowing funds throughloansor by issuingnotes.Unlike equity, debt has a specifiedinterest rateand a schedule of dates when interest is to be paid andalltheprincipalfully repaid.
Many fast-growing companies would prefertouse debt to support their growth, rather than equity, because it is,arguably,a less expensive form of financing(i.e.,the rate of growthof the business’sequity valueis greater than thedebt’sborrowingcost). But there muststillbesufficientoperating cash flow generated by the enterprise to “service” the debt’s interest and principal payment obligations,or therecouldbe severe consequences for the business,as noted below.
Reasons whycompanies mightelect touse debt rather thanequity financinginclude:
- Aloan doesnotprovide an ownership stakeand,so,does not causedilutiontothe owners’ equitypositionin the business.
- Debt can be a less expensive source of growth capital if the Company is growing at a high rate.
- Leveraging the businessusingdebt is awayconsistentlytobuild equity value for shareholders as the debt principal is repaid.
- Interest on debt is a deductible business expenses for tax purposes, making it an even more cost-effective form of financing.
- Debt can be somewhat less complicated to arrange than equity financing and may not require shareholder approval.
- There is a broad universe of lendersthatspecialize in various industries, stages of business and types of assets.
- Once the debt is repaid, it’s gone. Equity remains outstanding unless repurchased by the Company,which typically requires the shareholder’s consent.
Debt can be used to finance a wide variety of business activities including working capital (to acquire inventory, for example), capital expenditures (such as to finance equipment purchases) and acquisitions of other companies, to name a few. The term or maturity of the indebtedness should generally match theperiodassociated with the assets being financed. For example, inventory, accounts receivable and other short-term assets are usually financed with short-term debt that is less than one year in maturity. Equipment loans are normally three years or longer, andmortgageloansfinancingreal propertyare typically 15 years orlonger sincethose assets have longer useful lives for the business.
From the borrower’s perspective, debt has a fixedcost, theinterestrate, butitrepresentsasignificant potentialthreat tothecompany’sexistence. Ifinterest and principalare notpaid as agreed,lenders canforeclose,possibly requiringthe business tocease operations andliquidateits assets.Issuing equity, on the other hand, results in sharingfuture profitswith investorsbutis lessthreatening to the future of the business ifprofitabilitybecomesimpaired.
Debt is senior inliquidation preferenceto equity when a company’sassets are sold,reducingthe amounts availableto equity investorsfromanyasset sales, forced or voluntary.Though not obliged to do so, lenders may agree to restructure a non-performing loan byagreeing toforebearwhichoftenextendsthematurity of the loan, possiblywiththeaccrualofinterestduetolenders,albeit normally at a higherinterestrate.
From the investors’perspective, debt investments are also known asfixed incomeinvestments sinceinterest and principal payments are scheduled and areanticipatedafter the loan ornote investment is made. Equity investments, on the other hand,produce varying levels of return depending on the profitability of the Issuerover time.
WHITE PAPERS
VIDEOS
NEWSLETTER
Stay engaged with new knowledge base content and deals as soon as they hit the market.
INVESTMENT TERMS
In the interest of accessibility, here are some terms that any investor should be familiary with.
