In the accounting industry, financing remains an important concept, as many organizations are reliant on them for financial stability and longevity. Although there are a plethora of financing options and types to choose from, the focus of the work will revolve around debt and equity financing. These two commonly used forms of financing are important as they are both unique in how they are utilized. The author of this piece will address these two financing options while providing examples of each and addressing which capital structure is most advantageous.
Debt financing is the process of borrowing money from a lender such as a bank. These financings option comes in the forms of loans both secure and unsecured. “Security involves a form of collateral as an assurance the loan will be repaid. If the debtor defaults on the loan, that collateral is forfeited to satisfy payment of the debt” (Entrepreneur, 2014, p. 1). In most cases a lender will ask for some time of security on a loan and least often times will lend based on name recognition or status. One of the most common sources of debt financing is seen within startup businesses where debt financing is often provided by friends and family instead of commercial lending institutions.
“When borrowing money from relatives or friends, have your attorney draw up legal papers dictating the terms of the loan, as formalized documentation” (Entrepreneur, 2014, p.1). Another form of debt financing that is most common occurs with credit cards through a credit line. Credit cards are used to provide a way to businesses to get several thousands of dollars quickly without going through the hassles of getting approved for a loan and filling out vast amount of paperwork (Entrepreneur, 2014). Though this method is very popular it is important to take note that the interest can collect if not monitored as this debt can add up quickly.
Unlike debt financing, equity financing involves raising capital through selling shares within the business. “Equity financing essentially refers to the sales of an ownership interest to raise funds for business purposes” (Investopedia, 2013, p. 1). This form of financing does not just include selling common equity but it also consists of selling preferred stock, convertible preferred stock, and warrants. When a startup company gains success it will attain equity as it evolves. Since startups attract a vast amount of investors at different stages of the company’s evolution cycle, different forms of equity are used for the business’s financial needs.
Convertible stock is comprised out as a loan, which the company is obligated to repay and if company meets the specified benchmark in terms of performance, the unpaid balance of that loan is then converted into an equity stake in the business (Merritt, 2013). Companies can also attain capital by selling shares to investors. “This allows a company to give up a piece of itself as a way to raise money to finance growth. Small, privately held companies sell shares to private investors, who then hold equity within the company” (Merritt, 2013, p. 1). This is one of the quickest way for obtain capital to finance growth for a business, especially if it goes public.
Though both of these methods of financing are beneficial for a business to grow and obtain capital it is important to acknowledge which of these forms are most advantageous. In terms of raising mass amounts of money for growth and business operations, it would be most advantageous to utilize equity financing within the business as this provides are way for the business to attain large sums of money by selling shares. It is important to note that keeping account of the number shares is important as the business needs to ensure it maintains the majority of 51% of more to negate hostile takeover from competitors and other businesses. At times one financing on either forefront can seem to have more advantages then the next it is important the a business tries to utilize both in order to maintain balance and control of the business for optimal success.
Entrepreneur. (2014). Debt Financing. Retrieved from http://www.entrepreneur.com/encyclopedia/debt-financing
Investopedia. (2013). Equity Financing. Retrieved from http://www.investopedia.com/terms/e/equityfinancing.asp
Merritt, C. (2013). What Are Examples of Equity Financing? Retrieved from http://budgeting.thenest.com/examples-equity-financing-23831.html