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Opinion - How to decide between equity and debt financing

2021-10-04  Staff Reporter

Opinion - How to decide between equity and debt financing
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Development Bank of Namibia (DBN) CEO Martin Inkumbi once asserted that one solution can be found in equity finance for recovery. To understand this, I will elaborate more in detail on equity and debt financing. When it comes to equity and debt financing, there is a fine line between balancing risk and profitability in order to maintain the value of your business in the long run.

In most cases, after weighing the questions of equity and debt, most businesses opt for debt if they can get it. Debt is relatively economical comparatively, and equity can introduce a completely new paradigm into running the business. Rather evaluate equity against your own long-term objectives, your capabilities for growing the business, and the potential it offers. 

There are plenty of ways to mitigate a cash flow crisis or help your business during a crunch. Consider the merits of both equity and debt as you make your choice. Equity financing is where a portion of the business equity is sold in return for capital such as private investors, venture capitalists, friends and family, personal savings, amongst others. Debt financing involves borrowing money from a lender, in most cases a loan from the bank. 

This money is paid back over time, including any additional fees or interest. Before making any financial decisions, always ensure to do your due diligence and look into all available options. At the end of the day, you are putting your company in the hands of other people. And these people also play a part in the outcome of your business decisions. So, think wisely when choosing equity/debt financing to raise capital for your business.

Most companies use a combination of equity and debt financing, but there are some distinct benefits of equity financing over debt financing. Principal among them is that equity financing carries no repayment obligation, and provides extra working capital that can be used to grow your business. 

Businesses usually have a choice as to whether to seek equity or debt financing. The choice often depends upon which source of funding is most easily accessible for your business, its cash flow, and how important maintaining control of the business is to its principal owners. The debt to equity ratio shows how much of a company’s financing is proportionately provided by equity and debt. 

Furthermore, equity financing places no additional financial burden on the business. But that doesn’t mean there’s no downside to equity financing. In fact, the downside is quite large. In order to gain funding, you will have to give the investor a percentage of your business. You will have to share your profits, and consult with your new partners any time you make decisions affecting the business. 

The only way to remove investors is to buy them out, but that will likely be more expensive than the money they originally gave you. The right choice depends on your short-term and long-term financial goals and personal preferences. Debt financing is the better choice when you prefer to retain control of your operation, and you do not mind the trade-off of greater risk for higher earning potential. However, if you would rather share the risk, mitigate debt obligations and bring in top- level experts, invite equity investors.

The information I am sharing with you as an entrepreneur is to help make informed decisions. My aim is to see Namibian companies growing from SME to Corporate to grow our country’s economy. Therefore, I will continue sharing valuable information which will positively impact your business. If you accept some loss of control to equity investors, you may gain a significant amount of expertise. Some entrepreneurs take on equity investors as much for their expertise, industry knowledge and name credibility as they do for the money. A valuable expert who has money on the line may become a huge asset to the growth of your business. A lender leaves you alone, but you also gain no professional expertise with the funding. The effects of debt on the cost of equity do not mean that it should be avoided. 

Funding with debt is usually cheaper than equity because interest payments are deductible from a business’s taxable income, while dividend payments are not. In addition, debt can be refinanced if rates move lower, and eventually is repaid. Once issued, shares represent the perpetual obligation of dividends and a dilution of business control. Investors often view businesses that take on risk as dynamic and having potential for growth. 

They realise that to achieve higher returns, they will have to invest in riskier businesses. If a business is wise about its debt ratio and how it uses its increased profits, taking on debt can make the business more attractive to investors.  If you are uncomfortable with the idea of giving up a portion of your company to an outside investor, then equity financing is probably not for you. If you have a good credit score, you can get a low interest rate on your loan or avoid having to put up collateral, both of which can save you a substantial amount on the overall cost of the loan. 

In conclusion, both equity financing and debt financing can be helpful to your company. Once you evaluate your long-term business strategy, you’ll be able to decide which lending option will help you reach your goals.

 

*The opinions expressed in the article at that of the author alone, and are in no way linked to his employer or any affiliates.


2021-10-04  Staff Reporter

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