Week 5: Equity vs. Debt Financing

Most companies never seek angel investment or venture capital. This makes a lot of sense when you take a step back. Examples are all around us: the local grocery store, the gas station down the street, and so on.

Still, companies often need external money to fund operations. Where does this money come from? The company has two main options: it issues stock or it takes on debt (i.e. the company gets a loan).

The capital structure of a company is how the company has financed its operations. If the company issues stock to raise additional capital, the company is said to have an equity capital structure. If the company finances activities through assumption of a bank loan or issuance of a bond, the company has a debt capital structure.

Which of these approaches is better? There are several considerations. It is no coincidence that tech startup companies issue a lot of stock at the beginning: they probably couldn’t qualify for a bank loan! Equity, on the other hand, can be created out of thin air to represent percentage-wise the value of your company.

We’re all familiar with the meteoric rise of stock prices like Google and Facebook. As such there is a natural tendency to think of stock as the way to go when we need to raise money for our businesses.

Not necessarily! Taking out a loan or issuing a bond has some very attractive features to the business owner…so much that in his book, Rogers recommends companies fund their operations with debt. The reason is that taking on long-term debt can actually turn out cheaper than issuing stock.

Whereas stock is subject to double taxation (the income is taxed at both the corporate and the personal level), interest expense incurred when borrowing money is tax-deductible. Interest expense incurred on debt lowers taxable income.

Another consideration: while debt may be long-term, equity is forever.

Equity transfers some degree of ownership in your company to the hands of another. Once issued, that equity can be out of the founder’s reach forever, especially if your company is successful. Conversely, debt can be paid off, and if your company is successful, it can be paid off quickly.

Your business structure plays a role too. Issuance of stock in the way we typically envision basically necessitates you run a C-corporation, and that brings with the increased overhead and general greater complexity you see with that structure. Serious investors typically don’t want to deal with LLC “profit sharing” or some flavor of partnership.

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6 thoughts on “Week 5: Equity vs. Debt Financing

  1. Nick,
    Nice explanation between the two financing strategies. It sounds like if the founder wants to have more control and not worry about being kicked out of their company they should stick with the debt strategy.
    With all the discussions of cash flow in this class, the monthly debt repayment could cause trouble down the road when tough times hit.
    Cece

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  2. Hello Nick,
    You say: “Serious investors typically don’t want to deal with LLC “profit sharing” or some flavor of partnership.” I think this goes back to a business has a higher percentage of success if it is a soul proprietorship. If an investor have value to bring more than just funds is one thing but if it is funds only, great, just do not give up your control for money only.
    Mary

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  3. Nick,

    Very useful information and great explanation. Because my business is so small I would go with debt financing and just take out loans if necessary and like you said if your business is successful you can pay them off fast, so may not have debt for too long. I feel that equity and stock is for big corporate businesses like you said Google and Facebook.

    Thanks,
    Mackensie

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  4. Nick,

    Interesting concept below – Never thought of it this way. I always associated bad debt as badddd. lol I guess it all depends on how much debt and the size of the business maybe? Thanks for this

    Rogers recommends companies fund their operations with debt. The reason is that taking on long-term debt can actually turn out cheaper than issuing stock.

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  5. Hi Nick,
    I like that you offered a comparison of the debt vs. equity financing. As you point out, each has advantages and disadvantages. Which to choose really just depends on the business needs and aspirations.

    Interestingly, I did interviews with an investor and a banker recently. I asked them similar questions so my blog readers could see how they might approach financing. If you’re interested, check out the interview for Gregg Smith and Kim Stewart on my blog under the “Interviews” category.

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  6. Hi Nick,

    You did a great job of contrasting both equity and debt financing. I used to be very opposed to a debt of any kind, but the more I learn about business the more I understand that it can be a very useful (and even needed) tool in the entrepreneur’s arsenal. The reasons Roger’s gives to use debt instead of equity for financing are great points.

    Austin

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