Equity Financing: The Accountants Perspective

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Growing up, it has always been said that one can raise capital or finance businesses with personal savings, gifts or loans from family and friends, and this idea persists in modern business, but probably in different forms or terminologies.

It is a known fact that for businesses to expand, it is wise for business owners to leverage financial resources and a variety of financial resources can be used, generally divided into two categories, debt and equity.

Equity financing, simply put, is the raising of capital through the sale of shares in a company, i.e. the sale of an ownership interest to raise funds for business purposes and the purchasers of the shares are called shareholders. In addition to voting rights, shareholders benefit from stock ownership in the form of dividends and (hopefully) eventually selling the shares at a profit.

Debt financing, on the other hand, occurs when a company raises money for working capital or capital expenditures by selling bonds, bills, or notes to individual and/or institutional investors. In exchange for lending the money, individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid later.

Most companies use a combination of debt and equity financing, but the Accountant shares a perspective that can be seen as clear advantages of equity financing over debt financing. Chief among these are the fact that equity financing does not carry a repayment obligation and that it provides additional working capital that can be used to grow a company’s business.

Why choose equity financing?
• Interest is considered a fixed cost that has the potential to raise a company’s break-even point, and as such, high interest during difficult financial periods can increase the risk of insolvency. Overly leveraged entities (having large amounts of debt relative to equity), for example, often struggle to grow because of the high cost of servicing debt.
• Equity financing does not impose any additional financial burden on the business as there are no required monthly payments associated with it, so a business is likely to have more capital available to invest in growing the business.
• Periodic cash flow is required for principal and interest payments and this can be difficult for companies with cash problems or inadequate working capital.
• Debt instruments are likely to come with clauses containing restrictions on the company’s activities, which prevent management from seeking alternative financing options and non-core business opportunities.
• A lender is entitled only to repayment of the agreed principal of the loan plus interest, and to a large extent has no direct claim to future profits from the business. If the company is successful, the owners get a larger share of the rewards than if they had sold the company’s debt to investors to finance growth.
• The higher a company’s debt-to-equity ratio, the riskier it is viewed by lenders and investors. Consequently, a business is limited in the amount of debt it can take on.
• The business is generally required to pledge business assets to lenders as collateral, and in some cases business owners are required to personally guarantee repayment of the loan.
• Based on company performance or cash flow, dividends to shareholders may be postponed; however, it is not possible to do so with debt instruments that require payment as they come due.

Adverse implications
Despite these merits, it would be so misleading to think that equity financing is 100% safe. consider these
• Profit sharing, ie investors expect and deserve a share of the profits made after a given financial year, as does the tax collector. Entrepreneurs who do not feel like sharing profits will see this option as a bad decision. It could also be a worthwhile trade-off if the value of your funding is balanced with the right insight and experience; However, this is not always the case.
• There is potential dilution of ownership interest or loss of control, which is generally the price to pay for equity financing. A major financial threat to startups.
• There is also potential for conflict because sometimes sharing ownership and having to work with others could create some tension and even conflict if there are differences in vision, management style and ways of running the business.
• There are various regulatory and industry procedures that must be followed to raise capital funds, making the process cumbersome and time-consuming.
• Unlike holders of debt instruments, holders of shares suffer more taxes, ie both on dividends and on capital gains (in case of disposal of shares)

Decision Cards: Some Possible Decision Factors for Equity Financing
• If your creditworthiness is an issue, this might be a better option.
• If you are more of an independent individual operator, you might be better off with a loan and not have to share decision-making and control.
• Would you rather share ownership/equity than have to repay a bank loan?
• Are you comfortable sharing decision making with equity partners?
• If you are sure that the business could generate a healthy profit, you can opt for a loan, instead of having to share the profits.

It is always wise to consider the effects of your financing choice on your overall business strategy.

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