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  • Hinal Kapadia

Investing 101: Equity vs Debt

‘Debt’ is a word with generally negative connotations – when we hear it, we think of spiralling government debt and heavy borrowing, exacerbated by this Covid-19 pandemic. On the contrary, ‘equity’ tends to have positive implications – the shares that we can buy on the stock markets. However, both are types of financing that can help a corporation or government raise capital (money). Thus, we can say that business capital can be categorised into two forms – equity and debt. In this article, we will look at why corporations may choose to raise funds through equity or debt financing, and the differences between the two.


Why Raise Capital Through Equity?


When smaller corporations wish to raise a large amount of capital and have already exhausted bank loans, they want money that can help grow the business quickly, and support it in the long-run. Normally, long-term financing is done through raising equity from investors.

Venture Capitalists (VCs) are private equity investors who provide capital to emerging or start up companies in exchange for a stake in the business. Start-ups are risky, and three out of five go bust in the first five years of operating. Therefore, venture capitalists often demand a large stake in the business to ensure that they will make sufficient returns if the start-up turns out to be successful. You may wonder why a small start-up would want to optionally give away a [large] chunk of its business, but the truth is that, often, without the financial aid and advisory support of established venture capitalists, the start-up will fail. Private equity allows an infant firm the opportunity to expand, with the leadership, scalability, and funds of successful VCs.



Venture Capitalists (VCs) are private equity investors who provide capital to emerging or start up companies in exchange for a stake in the business. Start-ups are risky, and three out of five go bust in the first five years of operating. Therefore, venture capitalists often demand a large stake in the business to ensure that they will make sufficient returns if the start-up turns out to be successful. You may wonder why a small start-up would want to optionally give away a [large] chunk of its business, but the truth is that, often, without the financial aid and advisory support of established venture capitalists, the start-up will fail. Private equity allows an infant firm the opportunity to expand, with the leadership, scalability, and funds of successful VCs.


Once a business is large enough and can be self-sufficient, it may wish to raise equity through an initial public offering (IPO), by issuing shares on the stock exchange. Of course, you will already be familiar with IPOs, as you will have read our article on them that can be found here. Going public can generate large amounts of capital for the firm, and it generally assures the public with confidence in the company, as stringent procedures and regulatory requirements need to be followed in order to go public. According to Adam Hayes, “typically, this stage of growth will occur when a company has reached a private valuation of approximately $1 billion, also known as unicorn status. However, private companies at various valuations with strong fundamentals and proven profitability potential can also qualify for an IPO, depending on the market competition and their ability to meet listing requirements.”


Why Raise Capital Through Debt Financing?



Companies may raise capital through debt, rather than equity, when they do not wish to give up any ownership of the business. Because, instead of raising funds through issuing shares (that give investors a part-ownership in the business), debt functions in the form of loans from, or bonds to creditors. A loan is sum of money that is borrowed, usually from a bank or lending facility, and, in exchange, the borrower pays interest and the principal amount either in chunks, or at the maturity date. Similarly, a bond is an IOU that is issued by a public company as a promise to repay the amount borrowed on a specific date and pays a coupon, the interest rate for the bond, in exchange for borrowing funds. Issuing debt, whether short or long-term, can help entities raise a large amount of cash quickly to finance projects, spending, or pay off existing debt.


Key Differences:


- One of the main differences is that with equity capital, a restructuring of ownership takes place and shareholders own a stake of the business. Whereas with debt finance, the business owner maintains full control.

- In the case of a corporation filing for insolvency (going bankrupt), debt lenders are compensated first, as they are secured lenders who can exercise their power to recover what they are owed. On the contrary, equity investors rank last, meaning that they are less likely to recover the money that they invested. Therefore, investing in equities is deemed riskier than buying debt or bonds, as one must accept the possibility to lose their investment in a worst-case scenario.

- From a corporation’s perspective, debt financing is more attractive and cheaper than raising equity. Why is this? Well, debt is tax deductible – i.e. the interest or coupon that the company pays results in a lower profit, which equates to less money to pay tax on. On the other hand, dividends paid to shareholders come out of profit that is subject to tax, and so is regarded as the more expensive option.


Conclusion


Overall, both methods of financing raise capital, but, for many corporations, how they raise capital is dependent on the stage of growth of their business. Initially, many businesses start off through debt financing in the form of bank loans as it is a cheaper option. As the business grows and becomes more established, generating positive aggregate cash flow, equity financing is often considered as a viable option. Essentially, debt finance can help to meet short-term capital requirements, but equity finance can underpin the business to help reach the longer-term goals.