Businesses will from time-to-time experience financing deficits or need to grow. Proprietors or managers then have to choose between debt and equity sources of capital. Debt financing involves borrowing money which must be repaid while equity financing refers to selling an ownership interest in a business. What factors should inform a choice between the two paths? That depends on the answers to the following questions:
1. How much control are you willing to concede?
As is often said, the devil is in the details. The terms and conditions associated with capital injections may alter the decision-making process within a business operation. A company obtaining funding through a bond offering may be restricted from acquiring additional debt financing or using business assets as collateral during the bond’s term to maturity. On the other hand, issuing shares to new investors may dilute the decision-making authority of founding shareholders.
2. What is the capacity of the business to repay investors?
Holders of equity capital instruments such as ordinary shares enjoy an ownership interest in the business. They are more likely to wait patiently for returns on their investment over the long term. In contrast, debt capital sources have repayment obligations expected to be settled in the short-term. Therefore, a business raising capital through loans, bonds, debentures and similar instruments will need to generate sufficient cash flow to match interest and principal repayments.
3. What is the cost of available capital sources?
Cost efficiency is a major objective for business operations. Going for the most affordable sources of capital will hardly ever be a disastrous decision. During economic slowdowns, recessions and depressions, central banks lower their base lending rates to encourage lending to the private sector. The consequence is lower interest rates charged on loans, bonds and similar instruments. In such environments, acquiring debt financing or refinancing existing facilities to enjoy better terms becomes sensible.
4. Which source of capital is most accessible?
Unexpected opportunities are often not budgeted for and may require additional financing. A prime example is the rise in demand for face masks and sanitisers due to the Covid-19 pandemic. Many manufacturers had to reconfigure their existing operations to produce these in-demand products. In such a scenario, an entrepreneur should choose the most convenient way to acquire the needed capital.
Standard Investment Bank has over the years advised businesses on appropriate sources of capital and helped optimise their capital structures. Contact us at email@example.com for a more tailored conversation on sourcing capital for your business.
Thomas Juma is a Corporate Finance Associate at Standard Investment Bank