Many businesses, small or large, face this question every time they seek to finance their activities and inject cash into their economic machines. While “money for nothing” may apply to some musicians (if you played the guitar on the MTV in 1985), it usually comes at a cost for the firm seeking extra capital.
This cost is financially reflected by the weighted average cost of capital (WACC) –or how much financial cost a company is paying for access to both equity and debt-, but is also reflected in the opportunity cost of ceding ownership for equity. In any case of source of financing, there’s always a tradeoff from the perspectives of profitability, operations, and risk management.
Past and future profitability
Lenders will often look at the past profit history in order to determine whether or not to issue a loan. This is similar to a bank giving you a mortgage loan; in this case the bank would need to verify if your income history and credit rating allow you to repay the loan with interest.
On the other hand, investors are more interested in the future returns and what will be the company’s future cash flow. This is the reason why startups often seek venture capital investors to kick-start their businesses.
It is often the case that debt (loan or bond) is cheaper on the long term than equity is, but there is a limit to how much debt can be taken, as the debt still requires to be repaid.
The most common indicator for this level is the debt ratio, which divides the company’s debts over its assets. The benchmark for this ratio varies from one industry to another; companies with large physical assets and regular income would have a higher acceptable debt ratio than technology companies.
Impact on operations
The largest impact is actually on operations. While a loan needs to be repaid in full plus interest, none of the company ownership is ceded away (with some exceptions). This creates a large leverage in which a company benefits from the loaned capital, while not splitting the returns, and retaining complete control.
The situation is not the same with sharing equity, where in most cases the decision power is proportional to percentage of ownership of the firm. However, equity capital may open the door for advisory partnerships with the investors.
For example, besides funds, angel investors give business consultation and coaching to startup companies and provide access to their network, while benefiting financially on the longer term.
Even the largest of companies seek to maximize their debt in-lieu of giving away more equity. A large company would only issue new shares if it is already at a maximum viable debt ratio and must procure more capital to expand its operations. For starting small companies, the case would not be exactly the same.
A starter has smaller chances of acquiring sufficient capital in the form of collateralized loans, and hence would rely on outside investors to inject cash at the cost of forsaking part of the future returns (may be in dividend form, but certainly in appreciation of value). There may be however the alternative possibility, in some countries, to acquire small loans guaranteed by the government.
Balance of risk
From the business’ point of view, debt is riskier than equity as the repayment of loans is mandatory. Failure to meet this obligation puts the company at risk of being forced into bankruptcy by the creditors, liquidate the company, and go after the collaterals.
Shareholders, from the opposite side, are the first to absorb losses, and last to reap the rewards. In the event of a bankruptcy, the shareholders will be the last in line to collect the residual proceeds from the liquidation, and often times, there is none left.
This is one of the factors why investors ask for higher returns than bond buyers or bank creditors do, and why the cost of equity is considered higher than debt. The risk balance is therefore tipped towards the company itself in case of taking debt, and towards the shareholders in case of equity.
Overall, the question of debt vs. equity becomes more a matter of time, size, and accessibility. Companies will often seek a delicate mix between the two to ensure they have sufficient access to capital, enough control by the key shareholders, and a balanced risk between themselves, the creditors, and the investors.
In any scenario, it should be well noted that, the ultimate and cheapest source of cash must be the company’s own operations. External financing should never be thought as a substitute for income; it is only there –at a cost- to offset temporary expenses and investments, until the machine is well oiled and running on its own.
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