FINANCING OPTIONS AVAILABLE TO ENTREPRENEURS - PART II (DEBT VS EQUITY FINANCING)

DEBT FINANCING

Debt is defined as an amount  owed to a person or organization for funds borrowed. (investwords.com, 2011) while financing is defined as - to provide or raise the funds or capital (thefreedictionary.com) and as such debt financing can be described as to borrow funds from a person or organization for the purpose of raising funds or capital for a business.

Walter S. Good (2003) in his book Building a dream: A Canadian guide to start a business of your own defined debt financing as borrowing of money that must be paid in full, usually in periodic payments with interest. He also stated that it involves 3 important parameters: 

1.      The amount of principal to be borrowed

2.      The interest rate of the loan

3.      The maturity of the loan

It iIt is important to note that until the debt has been repaid the provider of the loan has legal claim against the assets and cash flow of the business. 

  

Contrary to the widely held notion that debt financing involve only banks there are different types of debt financing available. There are three major categories of sources for debt financing which are:

1.      Banks

2.      Government Initiatives

3.      Others ( further highlighted in the table below)

Debt financing as a means of funding a start-up business has both advantages and disadvantages and as stated in the last article the decision to make use of debt financing would depend on the preference of the entrepreneur. The table below highlights the advantages and disadvantages of debt financing.

EQUITY FINANCING

Equity financing can be described as a method of financing in which a company issues shares of its stock and receives money in return. Depending on how you raise equity capital, you may relinquish anywhere from 25 to 75 percent of the business. (Entrepreneur.com, 2011).

Such funds may come from friends and family members of the business owner, wealthy "angel" investors, or venture capital firms. Venture capital is one of the more popular forms of equity financing used to finance high-risk, high-return businesses. The amount of equity a venture capitalist holds is a factor of the company's stage of development when the investment occurs  , the perceived risk, the amount invested, and the relationship between the entrepreneur and the venture capitalist. Venture capitalists are private investors who provide venture capital for promising businesses.  (Smith J., 2008)

As with debt financing, equity financing also has its advantages and disadvantages which are highlighted in the table below.

DEBT FINANCING VS EQUITY FINANCING

Studies have shown that a 81% of start-up businesses by entrepreneurs are funded by personal savings as a form of debt financing from the owner of the business to his/her business.(U.S Chamber of Commerce Statistics and Research Centre, 2005)  In the event that these savings are in adequate or unavailable the choice of which form of financing is very critical to the success of the business.

It is a well-known fact that majority of entrepreneurs start-up businesses in order to escape from the shackles of working for a boss and as such ordinarily should be less inclined to consider equity financing as it dilutes the ownership of the business and  reduces their control over the business by involving investors who might have to be considered in the decision making process for critical decisions in the business and in the event that these investors hold a greater amount of shares than the owner of the business can easily over-rule the entrepreneur or in the worst case fire him or buy him out.

Having said this, the benefits of equity financing cannot be overlooked as have been highlighted above which clearly spells out the fact that apart from providing the much needed capital infusion into the business it also enhances the company’s credibility, net worth, financial strength and borrowing capacity in the future if need be, not to mention the wealth of experience and advice brought to the table by the investors who because of their vested interest in the company would do their utmost best to ensure the success of the business venture. (Benjamin G. and Margulis J.,2005).  Equity investors are looking for a partner as well as an investment, or else they would be lenders," venture capitalist Bill Richardson explained in Pacific Business News (Jefferson S, 2001).

As an entrepreneur embarking on a start-up business venture debt financing is also an attractive option as funds are provided while ownership of the company is still retained. It is also attractive because the debt may be acquired from a variety of lenders with the tem of the debt generally limited and loan payments predictable in addition to providing tax benefits. (Good S.W., 2003)

Eric Mais, Professor and chairman of the finance department of UH Manoi in the article When raising funds, start-ups face the debt vs. equity question in the pacific business news described the benefits of debt financing over equity in three words: Taxes, Leverage and Control (Jefferson S,2001). He further went on to explain that First, interest expenses on debt can be deducted from your tax liability. Secondly debt creates financial leverage as payment on debts are fixed and If a company has a good year, all they owe is their promise to pay interest, whereas if the same company used equity and had a good year, they would have to share all of that with investors. Leverage is both good and bad. Lastly, there is the degree of control the entrepreneur retains over the company. (Jefferson S, 2001)

On the other hand debt financing can also be seen as doubled edged sword that can cut both ways in that it is not without drawbacks.  For one it is extremely difficult to obtain as most financial institutions look at financing a start-up business with no track record and assets as risky and shy away from such obligations. The business also stands the chance of taking on more debt than the business needs which can be a burden on cash flow and if funds are not used judiciously might lead to a difficulty in repaying these loans. (Good S.W., 2003)

The most prudent course of action is to obtain capital from a variety of sources, using both debt and equity, and hire professional accountants and attorneys to assist with financial decisions. Ideally, experts suggest that businesses use both debt and equity financing in a commercially acceptable ratio. This ratio, known as the debt-to-equity ratio, is a key factor analysts use to determine whether managers are running a business in a sensible manner. Although debt-to-equity ratios vary greatly by industry and company, a general rule of thumb holds that a reasonable ratio should fall between 1:1 and 1:2.

The financial ratios indicate something about a company's activities, such as the ratio between the company's current assets and its current liabilities or between its debtors and its turnover in the case of a start-up business the projected current assets and liabilities. The basic source of these ratios is the company's projected profit & loss account and balance sheet that contain all kinds of important information about that company. The ratios really help to bring those details to light and identify the financial strengths and weaknesses of the company. (Hovakimian et al., 2001)When assessing ratios, it is important that the results are compared with other companies in the same industry and not to be taken in isolation. What may seem like a poor ratio at first glance may well be normal for that industry and, of course, the reverse applies, in that what may seem a good ratio on its own, could be below average for that industry. The most common ratio used to measure equity to debt and debt to total asset:

Equity to Debt =    Total Owners Equity /  Total Debt

Debt to Total Asset =      Total Debt  / Total Asset


LOOK OUT FOR PART III OF THE SERIES - A CASE STUDY SHOWING A PRACTICAL DEMONSTRATION OF WHAT HAS BEEN DESCRIBED ABOVE.
Ps: A list of all references would be provided at the end of the entire series.