When in need of financing a company stands before the choice of whether to use debt or equity financing. Debt financing is when funds are borrowed from for example a bank or a friend, whilst equity financing is when an investor receives ownership interest in the company in exchange for funds or assets. Debt as well as equity can be structured in different ways, and the distinction may not always be fully clear, as the case may be with convertible debentures or loans where the interest rate or repayment obligation is correlated with the results or financial standing of the Company.
On a very high level, two of the main advantages of traditional debt financing are that the creditor does not get any direct influence over the business and that the relationship with the creditor usually is terminated when the debt is repaid. On the downside, debt financing is normally subject to interest, which varies depending on the risk the creditor takes by lending money to the company. The repayment may also slow down the development of the company and if the debt is not repaid it may lead to bankruptcy. As creditors can be reluctant to provide loans to smaller companies, the debtor might be asked to deposit securities or to comply with certain specified requirements. For smaller companies this often entails that the people behind the company may be asked to deposit securities and the fact that the company is limited by shares may thereby be circumvented. Loan facilities are also often combined with covenants and undertakings, granting the creditor influence and control over the Company.
Through equity financing, the investor takes all the risk and repayment of the funds (typically through dividends) can only be done when this cannot lead to bankruptcy or otherwise significantly disrupt the company’s operations. The downside is that investors are granted influence over the company’s business and share potential profit with the other owners (dilution). On the other hand, an investor might provide the company with more than just monetary funds as they may have knowledge or other resources that may be of use for the company’s business and future growth.
Whether a company should use debt or equity financing depends on what the owners of the company prioritize, the prospect of future success of the company as well as in what stage the company find themselves in. The two forms of financing can also be combined.
If you would like to know more about the legal aspects of financing companies, please contact Oskar Belani.