Equity financing and debt financing are two alternative ways which assisted us to start a business. In addition, equity financing and debt financing were the useful methods when a company lacking of funds for the expansion in order to open a new plant.
Equity financing is one of the ways to increase the funds of the business. It means that more funds can be obtained by sell their ownership interest to the public in exchange for funds and normally it does not have to be repaid. Equity financing are not refers to the owner itself put in the money into the business but the third party investors. Generally, the third party investors included public shares and also preference share. Examples for public share are venture capitalists and angel investors whereas for preference share are friends and family, employee and so on can be uses equity financing as a source of funding. (Jose Valdez, July 2005)
Pros and Cons of Equity Financing
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The advantage of using equity financing is the owner of the business is unnecessary to take out the money and invest to the company because the business already has enough sources of funds from the investors. For instance, such investors like venture capitalists, they do not expected to get an immediate return on their investment but they looking for the growing potential of business which may increasing the investment value in the future. For the angel investors, they are slightly different to the venture capitalists. Angel investors are less aggressive and tend to be one or more investors. Their investment to the business is in the form of loan that secured by the equity. (Thomas Ajaya, Dec 2010)
The disadvantage of the equity financing is the owner of the business has to pay back the interest for the investors. It means that the profit of the business is being share among the owner and the investors. And the business owner may probably lose completely control and autonomy of the business because equity financing is depends on ratio of the investment between the owner and the investor. If the investment of the investor is more than the owner then the owner of the business may take risk to lose the autonomy of the business. (Rosemary Peavler)
Debt financing, in the other words, is another type form of loan. In simple words, debt financing is some kind of borrowing action from a lender or investor that must be repaid with interest with certain fixed amount in the future and it does not dilute the ownership of the company. Instead of that, the charges of interest rate on the borrowed funds also proportionally reflect the level of risk that the lender might be face by provided funds. For instance, most of the lender or investor, they will charged a higher interest rate of a new start up company compared to the company which has shown a profit for several years.
There are several types possible methods for debt financing are available for small business such as private placement of bonds, convertible debentures, industrial development bonds, and leveraged buyouts. Besides, Debt financing also can be classified in short-term which has a maturity shorter than two years, long-term which has a maturity longer than one year or a credit line for more immediate borrowing needs. For most of the methods that have been mentioned above, they are admitted by the co-signers, guaranteed by the government, or secure by the collateral.
Pros and Cons of Debt Financing
Like the equity financing, debt financing also has both advantages and disadvantages. The main advantage is that a greater degree of financial freedom is provided for debt financing business owner if compared to the equity financing. When the borrower has no further claim on the business, the loan repayment period are limited for debt obligations. Whereas for the equity financing, the investorsâ€™ claim does not end until their stock are completely sold off. In addition, a debt that paid on time can increase a businessâ€™s credit rating and can be making it easier to obtain other types of financing in the future. Furthermore, debt financing tends to be more expensive over the short-term, and less expensive over the long-term when compared to equity financing.
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On the other hand, the main disadvantage of debt financing is that the regular monthly payment of principal and interest of the loan are required. It mean that, when a business is in shortage, meaning that the business are facing the cash flow problem which are could cause the business unable to making payment for loan to the borrower and the penalties for late or missed payment were charged due to the late or missed payment. When the business fails to making payment on time, it may adversely affect the businessâ€™s credit rating and its ability to obtain future financing. Finally, the amount of fund for a small business may be obtain through debt financing is possible to be limited and it may caused them need to use other sources of financing at the same time as well.
For the business like IFCA Sdn Bhd which is a medium sized manufacturing company that is more suitable to use debt financing compared to the equity financing. Since the IFCA Company is in form of Sdn Bhd, because it cannot issue public shares to get the funds so that the easier way that could get fund from others is using debt financing. Besides, if the IFCA Sdn Bhd is using debt financing although it needs to repay loan for several years but it bring the benefit to the company which is tax deductible because of the payment of loan interest. In overall, debt financing is considered a valuable option for IFCA Sdn Bhd to begin their business. But if there is carrying too much debt for the company will affect the businessâ€™s credit rating and its ability to obtain future financing and may cause the business to encounter severe cash flow problem. Therefore, it is best to use combination of different form of financing to spread out the risk and facilitate future funding efforts.