Many companies require additional financing to effectively run their firm. To receive the money required to run a business, many businessmen utilize debt or equity financing. Both financing methods allow individuals and enterprises to receive the finances needed to continue operation of their business. Although equity financing does not require a business owner to repay funds, debt financing may be more beneficial to the entrepreneur.
Debt financing is best defined as a loan. When a business owner needs funds to pay for equipment or employee wages, he or she may turn to the banking system to receive a loan. The banking institution then becomes a creditor to the company and the owner must refund the credit and interest on the loan provided. Susan Ward, from About.com defines debt financing as, “borrowing money from an outside source with the promise to return the principal, in addition to an agreed upon level of interest”. Although a bank is a primary source of financial loans, debt financing can be provided from individuals or organizations.
An example of debt financing can be seen in long term and short term debt financing. An entrepreneur may need “equipment, buildings, land, or machinery” to start their business, (Ward, 2008). The business owner can go to the bank, ask for a loan, and receive the funds need. However, the owner is allowed 1+ year to pay back the loan and interest. The same is true for short term debt financing. However, this type of debt financing, “usually applies to money needed for the day to day operations of the business such as purchasing inventory or wages”, (Ward, 2008).
Equity financing is more complicated. Although an entrepreneur does not pay back an investor for the money put into the company, the owner is required to give up a portion of his shares to the investor. Consequently, equity financing is defined as “the method of raising capital by selling company stock to investors”, (“equity finance”, 2012). If a business owner funded half a million dollars into the business and needs another half million to make necessary purchases, an investor can provide the funds. However, instead of paying monies back the entrepreneur must give the investor half the shares of the company, who will then own 50% of the company. The same owner may ask his sister and brother to invest instead. If each invest a quarter of million, then the brother and sister will each own 25% of the company.
Both debt and equity financing has their incentives and drawbacks. Although an owner does not pay back the money invested, he is ultimately giving up some of his rights to the company. This may be problematic for an individual who wants to have full control over business decisions. An investor may choose to sell his shares to other investors, adding additional shares to outside parties. Furthermore, an investor may push company mergers or public stock options. Thus, debt financing is a likely source of business financing. The owner does not have to give up his share nor compromise decision making. In addition, “principal and interest payments on business loans are classified as business expense and thus can be deducted from your business income taxes”, (Ward, 2008). Consequently, debit financing provides additional advantages over equity financing.
Equity finance. (2012, March 15). Retrieved from http://www.investinganswers.com/financial-dictionary/stock-market/equity-financing-1523
Ward, S. (2008). Debt financing. Retrieved from http://entrepreneurs.about.com/sitesearch.htm?q=what is equity financing&SUName=entrepreneurs