A common question is, “What type of capital structure is best for my company?” The answer to that question is individually dependent upon your company, its stage of development and its needs. In the broadest sense there are two types of financing, debt financing and equity financing. Let’s take just a minute to consider the broad implications of both.
Debt financing is the infusion of capital by an investor in exchange for an agreement or repayment and interest over a specified period of time. Debt is usually backed by collateral and subject to other restrictions the investor may impose to secure their position. Common examples of debt capital are loans and the issuance of bonds. Debt may be an attractive means of securing capital for your company because you are not required to give up equity in exchange for the infusion.
However, carrying debt on your balance sheet requires that you have sufficient cash flow to make periodic interest payments, projected resources to pay off principal at the time of maturity and collateral necessary for securitization. Debt financing is many times not an option for early-stage companies because of lack of positive cash flow. An exception could be debt put in place alongside owner’s cash for the purchase price of hard assets, such as plant equipment or real estate, that’s liquidation price would be sufficient to cover the amount of the loan
Equity financing is the infusion of capital by an investor in exchange for stock in the company. Equity issued to investors in exchange for cash can take many forms such as common stock, preferred stock or warrants. Common equity investments are those made by venture capital funds, angel funds and hedge funds. Whatever the agreement structures, equity investors expect a return in the form of dividends and appreciated stock value at the time of a company sale or public offering.
Equity financing may be attractive because it allows for an infusion of capital into your company without the immediate cash obligations associated with debt service. Additionally, bringing in equity investors means that you’re bringing in new owners and possibly new board members which may change in the corporate culture. Many times, these new owners are experienced business people in their own right and can offer management valuable insight and perspective as your company grows and changes.
While equity financing does not make significant demands on cash flow, except when dividends are paid, it can come at a high price. Equity investors take on a lot of risk when investing in your company at an early stage but generally reap handsome returns on their investment at the time of company sale or public offerings.