Equity funding enables owners to profit without giving up ownership or control, as opposed to debt financing, which entails borrowing money that must be repaid with interest. Most companies choose a combination of debt and equity to balance their capital structure.
Understanding both options can help owners determine what is best for their business.
Flexible and Strategic Capital Solutions
When companies need to raise capital, they have two financing options: debt or equity. These options refer to how companies can obtain funds to finance their operations or growth. Equity finance includes selling firm shares to investors in return for capital, whereas debt financing involves borrowing money from lenders. When a company raises equity capital, it sells ownership shares to investors.
Most companies choose a mix of the two financing methods to achieve their goals. The most significant benefit of equity financing is that there is no need for repayment, giving the business extra working cash for expansion.
As a result of this opportunity set, we’ve seen increased demand for tailored capital solutions that address the paradox of early-cycle growth expectations and later-cycle valuations. These capital solutions include structured equity, which can be customized through negotiation and span the middle ground between debt and equity (see Figure 4). This structure delivers contracted returns without cash-pay interest to investors, creating attractive value.
Management must consider the impact on its Weighted Average Cost of Capital (WACC) when deciding between debt or equity financing. WACC calculates all the costs associated with a company’s capital structure, including the company’s debt and equity.
The higher the WACC, the more costly it is to raise debt or equity. A high WACC may be due to factors such as the cost to issue new stock, interest rates, or the tax rate on corporate earnings. That is why many businesses choose to utilize a combination of both debt and equity financing. With this type of financing, the business will surrender some ownership and control to the investors, but it doesn’t have the burden of a repayment obligation.
While debt financing keeps ownership with the company, it burdens the business with repayment and interest charges. It also dilutes the company’s equity and pressures stockholder returns. Equity financing, on the other hand, does not require any repayment or interest and is more flexible.
For anyone in the finance industry, understanding these two types of funding mechanisms is essential for making sound decisions. Whether you’re looking at acquiring discounted public debt or swapping debt for equity to achieve targeted returns, it’s necessary to understand the differences and the pros and cons of each type of financing. It will allow you to recommend the most suitable solution for clients.
Other Capital Solutions
In light of COVID-19 heightened credit demands and forecast uncertainties, companies should consider alternative capital solutions. These may include preferred equity, mezzanine debt, and convertible debt instruments that offer a combination of both debt-like characteristics (fixed-income yield) and equity upside through warrants or other equity components.
Capital is fundamental to running any business daily and financing its future growth. Understanding the different types of capital solutions allows a company to strategically evaluate its options for funding and make the best decision that meets its unique business needs.
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