Every business requires some capital to get things moving. Apart from having your ready cash to start and run your business, you may also want to consider external sources of financing. That is equity financing and debt financing. The money needed to run the firm that comes from shareholders is referred to as Equity Funding and on the other hand, money from lenders to finance business activities is called Debt Funding. Determining the type of funding to go in for is very critical because both have its merits and demerits. A mistake in determining the right funding can huge impact on the firm as a whole.
Equity is the portion of the firm that belongs to shareholders or owners. Shareholders only receive dividends when the board of directors decide to share the firms profit with shareholders.
Debt is a common name given to all borrowed funds. These funds come from banks, bondholders, government. For most small business, suppliers also constitute a major lender that is if you buy on credit thus any product or service you buy that you are yet to make payment for. Unlike dividends to shareholders, the principal and interest on the debt cannot be postponed and failure to honor these obligations can end up been entangled with legal suits.
WHEN TO CHOOSE EQUITY FINANCING:
Equity is a much better source of funding if you are operating in an uncertain business environment and it is likely you are not going to make profits for a while. Start up businesses with great ideas but little experience due to the liability of newness often fit these criteria. Borrowing heavily to finance such an operation can cause havoc, because the payment might be due before the firm gets the chance to get up on its feet. Equity is also preferable when lenders charge excessive interest rates on loans which is the nightmare of many startups. If you are unable to generate the profit you expect, shareholders have to absorb the loss and have no legal course of action, provided that they haven’t been defrauded.
WHEN TO CHOOSE DEBT FINANCING:
You should rely more on debt as opposed to equity, if you expect to be highly profitable. If borrowing funds will earn extra cash then it is better than bringing in new shareholders or owners. More owners or shareholders mean having to divide the profit into smaller pieces. However, do not rely on debt if you are uncertain of your repayment abilities. An unpaid lender, however can sue and seize your assets or even force you into bankruptcy.