When is Debt Better than Equity Finance?
The secret to choosing the right investment mix for your business.
As food is to human growth, so is finance for business growth. Personal capital and hustle can only take your business so far. To get continuous expansion for your business, you must eventually explore external financing.
Now, external financing can take many forms. It could come in the form of grants (which most people prefer because they consider it free money), equity or debt finance.
Equity vs Debt
Equity financing is simply, exchanging a share of your business for money from your investors. The main advantage of equity financing is that you don’t have to repay the investments. However, it is considered more costly than debt finance because of the potential for your business to grow, causing the value of your shares to be worth more than what you sold it for.
Debt financing on the other hand, is the borrowing of money for repayment at a future date. Business owners take loans from lenders and repay the lenders more than they initially borrowed. The major advantage of debt finance is its fixed nature which means you can predict it and plan for it. It is also tax-deductible, meaning that any repayment you plan to make will be subtracted from your profits before tax is calculated (on your profit). However, its fixed nature can also be a disadvantage, depending on how well your business performs. This is because the funds must be repaid, whether or not your business performs well.
For example, if you need a loan of N250,000 for your business, you can either take a loan at 10% per annum or sell 25% of your business for N250,000.
If you choose to go for equity financing, you will have zero debt and no need to repay, but you will keep only 75% of your profit. This means that if, in 2021, you make a profit of N1m, you will only keep N750,000, the remaining N250,000 belongs to your investor.
If you go for debt financing, you will repay 25% of the loan amount as interest expense every year, depending on the terms of the loan. This means that if you make N1m in 2021, you will keep N975,000 and pay N25,000 as interest. This is the advantage of the fixed nature of debt finance.
On the other hand, if you make just N26,000 in 2021, with equity finance, you would get to keep N19,500 and your shareholder would get N6,500. However, with debt finance, you would need to repay N25,000, leaving you with just N1,000. This is the disadvantage of obligatory repayments.
The Bottom Line
If you are a business owner in a stable industry with consistent cashflows, then debt financing might be an effectively cheaper option. However, small start-ups or companies in risky industries with high uncertainty might find it difficult to obtain debt finance and should lean more towards equity.
* If you would like to get a grant for your business, stay tuned for our upcoming workshop, tagged “The Money Conversation” for actionable insights from a renowned expert. Follow us on Twitter and Instagram at @smefinancehub for firsthand access to webinars and workshops.
