Choosing the right capital mix can have a big impact on a company’s ability to adapt, invest, and thrive. Implementing a capital strategy that supports a business’s overall objectives and growth trajectory can mean the difference between success and failure.
Here’s what you need to know when deciding between equity capital and debt capital.
What is equity capital?
Equity capital refers to the funds a business raises by selling shares, representing ownership interests in the company. It allows a company to obtain the resources it needs without incurring debt.
When investors make an equity investment, they buy a stake in the company. This stake entitles them to a share of the company’s profits and may grant them certain voting rights in corporate decisions. The performance of their investment is directly tied to the success and growth of the business; as the company's value increases, so does the value of their portion of the company.
The advantages of equity capital
Equity capital offers several advantages for both companies and investors. A few of the biggest benefits are:
No repayment obligation. Unlike debt financing, equity capital does not need to be repaid.
No interest. Equity financing does not involve interest payments.
Access to additional resources. Investors often bring more than just capital. They can offer valuable resources such as expertise, industry contacts, and strategic guidance.
Considerations for leveraging equity capital
Equity capital, while beneficial for raising funds without incurring debt, comes with its own set of disadvantages:
Ownership dilution. When a company issues new shares to raise equity capital, it dilutes the ownership percentage of existing shareholders.
Loss of control. With new shareholders comes the potential loss of control for existing owners. New investors may have voting rights that can influence the company’s strategic direction, potentially leading to conflicts with existing shareholders' visions or goals.
Cost. Generally, the cost of equity is higher than that of debt because investors take on more risk by investing in equity.
Market changes. Equity capital exposes the company to market fluctuations. This can lead to volatility in the company’s capital structure and impact its ability to raise further capital.
Pressure for performance. Once a company has investors, it faces constant pressure to meet forecasts and show continual growth.
What is debt capital?
Debt capital is a form of financing in which a company borrows money to be repaid later. This borrowed capital can come through various instruments, including bank loans, bonds, or credit facilities, each with specific terms. When a company opts for debt financing, it engages in a credit agreement with lenders. The terms detail the borrowed amount, interest rate, repayment schedule, and associated covenants or restrictions.
Loan covenants can be a significant aspect of debt capital, especially in large debt deals. These covenants may limit the company's future borrowing, restrict dividend payments, or mandate a certain level of liquidity. Adherence to these covenants is monitored through regular financial reporting to the lenders. Non-compliance can trigger corrective actions, including renegotiation of loan terms, imposing penalties, or, in extreme cases, demanding immediate repayment.
While debt capital offers the advantage of not diluting company ownership, it introduces fixed obligations in the form of regular interest payments and the eventual repayment of the loan principal, which the company must manage alongside its operational expenses.
Advantages of debt capital
Raising debt capital offers several advantages to businesses. Here are some of the key benefits: Maintain ownership. When a company uses debt to raise capital, it doesn’t have to give up equity or ownership stakes to investors.
Flexibility. Debt instruments can be structured in different ways to fit the borrowing company's needs, including the amount borrowed, the duration of the loan, the interest rate, and the repayment schedule.
In the case of fintech platforms and other types of specialty lending companies that can make use of asset-backed debt, cash flows from an asset-backed loan can help accelerate originations.
Predictability. Debt agreements typically include fixed repayment schedules, which can help financial planning and cash flow management. New companies are even making it possible to view and analyze credit spreads within private credit.
Speed. Issuing debt can often be quicker than equity, especially for facilities like lines of credit or short-term commercial paper.
Considerations for debt capital
While debt capital can offer several advantages, it comes with its own set of considerations, including:
Repayment obligation. Regardless of the company's financial performance, debt has to be repaid at the agreed-upon times.
Financial risk. High debt levels increase the company's financial leverage, which can amplify the potential returns—and the risks. The cost of debt includes regular interest payments, which can be a financial burden on companies.
Asset risk. In some cases, debt is secured against company assets. If the company fails to meet its debt obligations, creditors may seize these assets.
Covenants and restrictions. Debt agreements often come with covenants or restrictions that can limit a company’s operational flexibility.
Equity capital vs. debt capital: three key differences
Equity capital and debt capital are two fundamental sources of funding for businesses. Each type of capital has its strategic uses, benefits, and risks. Companies often use a mix of both to balance the advantages and disadvantages, optimizing their capital structure for growth, flexibility, and financial stability.
Here are three key differences to think about:
Ownership and control implications. With equity capital, investors receive company shares, which typically come with voting rights. Issuing equity can dilute the existing owners' control over the company. With debt capital, the company retains full control over its operations and decision-making if it adheres to the covenants or agreements made with the lenders.
Financial risk and repayment obligations. With equity capital, there’s no obligation to repay investors if the company doesn’t succeed. Companies that use debt capital must repay the principal amount plus interest, regardless of their financial performance.
Cost of capital and potential returns. Equity capital is typically more expensive than debt capital because investors expect a higher return due to the higher risk of loss. Debt capital is generally less expensive than equity but increases the liabilities on the balance sheet.
Want to learn more about Finley?
Finley is private credit management software that helps private credit borrowers and asset managers streamline and monitor asset-backed loans. From tracking covenants and deliverables, to assembling funding requests and analyzing asset performance, Finley gives borrowers and lenders peace of mind when it comes to debt capital management. For more, check out our Product page.
If you want to learn more about software that can help you streamline your debt capital raise and management, just schedule a demo. We'd love to chat!