Taking on high-level financial management decisions for a large corporation requires a thorough understanding of the available financing options.
When it comes to choosing corporate financing, experience will dictate whether debt financing or equity financing makes more sense. Professionals involved in financial management may choose one or the other depending on business goals. They may also decide to use a mix of both to achieve the best results for financing the company.
Economic climate often dictates which option is more available. As seen at the end of Q4 2022, hesitancy in lending from both creditors and venture capitalists led to harder-to-secure debt financing.1 Indeed, the market was weighted more heavily toward equity financing, with it holding about $22.9 billion to just $9.3 billion in debt.1 External forces also may be a deciding factor for many corporations when choosing between debt financing and equity financing.
But still, corporations should consider both options before making a final decision on financing. Weighing the pros and cons of both debt financing and equity financing can help determine when one method is more appropriate than the other. Participants in graduate work should be prepared to evaluate these options in their professional roles, backed by an academic understanding of both financing options.
Consider the following factors in decisions related to corporate financing options.
Debt financing is a popular option in the corporate world because it allows companies to start from scratch. Without needing to have cash reserves, businesses can borrow to finance growth. For startups who may not have much equity to offer as a financing option, turning to borrowing may be the best choice. But borrowing can place some limitations on business growth, so businesses must weigh the pros and cons.
Pros of Financing with Debt
When businesses need to raise capital, debt financing is likely the first thought in many financial managers' minds. There are many ways to borrow for financing. Some ways to utilize debt financing include:
- Mortgaging property: A cash-out refinance can help raise money from owned property
- Taking on business loans: Some businesses may qualify for loans to secure funding
- Bond insurance: Businesses may be able to sell bonds to raise funds now and pay bond holders interest later
- Peer-to-peer lending: If bank loans aren’t the right fit, borrowing directly from a peer lender may be another option. These loans may come with less favorable rates
- Business credit cards: Businesses can apply for credit cards to make spending or financing purchases simpler
- Invoice factoring: To quickly raise funds, businesses may sell outstanding accounts receivables to another company for the total amount less fees2
While each of these borrowing options comes with different terms and conditions, they offer similar opportunities to leverage debt for funding. For example, a business hoping to expand to a second location may consider mortgaging current property to raise funds. This helps them utilize an existing asset to secure funding.
Riskier business proposals may discourage banks from offering a business loan to a startup. Instead, they may want to turn to peer-to-peer lending. Being able to work directly with a peer lender can help a business sell its plan and leverage debt even with a niche proposal.
Cons of Financing with Debt
Debt financing can put long-term pressure on the finances of a company long after giving its finances an initial boost. Owing money with growing interest over a long period can limit opportunities and even restrict further growth.
Before choosing to use debt financing, experienced financial managers must evaluate whether the company is prepared to pay back the debt over a long period of time without doing damage to the growth they wish to fund. Understanding the potential interest terms associated with their chosen form of debt financing is important.
For example, if they opt to mortgage a property with a fixed-rate loan, payments will remain consistent and expectable. But if they utilize business credit cards with variable interest rates, changes in the economic climate could affect the rate significantly. Hikes in interest rates may make debt repayment suddenly untenable, perhaps canceling out any potential growth.
When businesses finance with equity, they sell off a percentage of ownership to raise capital. This can be ideal for startups or mid-size businesses with valuable equity looking to grow, as it provides funding without debt.
There are several different ways to use equity financing, including:
- Taking a company public: Listing a company on a stock market raises funds from stock sales to investors
- Contacting venture capitalists: Later-stage companies may seek venture capitalists to invest in their company for a share of equity3
- Exploring corporate or angel investors: Large corporations or angel investors interested in startups may provide funding in exchange for equity3
- Crowdfunding: Appealing to the public and potential customers for backing is another option4
Depending on the financing needs of the business, one equity leveraging option may be preferable to another. Startups, in particular, may benefit from grassroots crowdfunding that excites a potential audience. More traditional, established companies may pursue venture capital or individual angel investors to purchase a percentage of their equity.
Pros of Financing with Equity
There is no need to borrow or raise funds when financing with equity. Businesses benefit from leveraging equity as a financing option because it utilizes what they already have to fund growth. There are no over-hanging debt payments or growing interest balances to threaten the financial sustainability of the company.
Equity financing also helps bring other voices to the table. When businesses sell off equity, new shareholders may bring their own experience and interest to the boardroom. For many businesses, having this kind of knowledge on board can be a boon.
Cons of Financing with Equity
While equity financing does not lock a business into owing money, it does sacrifice a piece of ownership. This can trim profits later on and perhaps complicate leadership decisions depending on the size of financed equity.
Needing to consult with new co-owners of the company may complicate business decisions. If it comes to a place where the company can no longer reach a consensus with investors, a buy-out is necessary. Due to the fact that time has passed and value has likely increased, the company would have to buy out the investors at a higher cost than they originally sold the percentage of ownership.
Yeshiva University MBA Students Prepare for Corporate Finance Success
As a student in the Syms School of Business online MBA program, prepare for success as a leader in corporate finance. Engage with concepts in corporate finance that will prepare you to make high-level decisions about when to use debt financing and when to use equity financing. Confidence in balancing funding options will help you expand your role in the corporate world. Learn more about the program when you reach out to an Admissions Outreach Advisor today.
- Retrieved on May 25, 2023, from capitaladvisors.com/debt-market-quarterly-update-2/
- Retrieved on May 25, 2023, from wallstreetmojo.com/debt-financing/
- Retrieved on May 25, 2023, from cointelegraph.com/news/angel-investors-vs-venture-capitalists
- Retrieved on May 25, 2023, from investopedia.com/ask/answers/042215/what-are-benefits-company-using-equity-financing-vs-debt-financing.asp