Debt versus Equity: How Should You Fund Your Business?

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Funding Souq Editorial Team
Tech Writer
Apr 05, 2024
Funding Souq’s editorial team comprises experienced finance and investment professionals that are on a mission to fuel SME growth, create jobs, and drive the economy forward. They aim to share their extensive experience and industry know-how to empower entrepreneurs and investors alike.
Apr 05, 2024
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Everything comes with a price – even money. If you want your company to be the next unicorn, you’re going to need financing. Most successful firms use a blend of debt and equity to fund operations and expansion. Is it the right time to take out a loan? Should you instead sell a stake? Here are some factors to help you decide.

 

What Are The Different Types of Debt Financing?

 

Debt financing takes myriad forms, but the logic is typically the same: borrow what you need now and repay later, with interest.

Traditional bank loans offer a lump sum of capital to be paid back on a fixed schedule. That’s ideal for large, long-term plans, like purchasing a new building or factory. A simple line of credit can be great for short-term needs, like payroll.

 

Bond issuances essentially work the same way – you get a large sum of money now and repay your creditors later, with interest. More creative forms of debt financing include invoice factoring, which means you transfer unpaid invoices to a third party in return for cash now, with a fee of course.

 

Why Choose Debt Financing?

 

Debt can be the smart path to expansion. Sure, you may be able to use your revenues to scale up. But that might not be the wisest use of your money, especially when interest rates are low.

 

Unlike equity financing, debt generally gives you tremendous latitude over how to spend the money. Bank lenders may impose conditions, but there’s little intervention on your business. You may need assets for collateral, but you’ll maintain company ownership.

 

Can I get a Good Rate With Debt Finance?

 

With debt finance, the key question is how much it will cost to pay back. The price of borrowing  has soared since the Federal Reserve began hiking its benchmark rates in March 2022, from nearly 0 percent to 5.25-5.50 percent. That’s pushed up interest rates globally. The Fed has said cuts are coming before year-end, but for the moment they’re at the highest level in over 23 years.

 

 

In simple terms, that means loans today are much more expensive than they were before March 2022. Small businesses are typically the most affected by rate hikes because banks already offer them higher interest rates than large firms.

 

Can you qualify for a loan?

 

That assumes you can even get a loan. Small and medium-sized enterprises (SMEs) in particular struggle to get financing. That’s why the Arab world has a roughly $123 billion SME finance gap. In the UAE, only 5 percent of bank lending goes to SMEs, a rate below global averages. 

 

To get a loan you’ll need a good credit score, strong financials and collateral, at least if you want a competitive rate. The silver lining is that repaying debt over time will build your credit score, which will help you get better rates in the future.

 

If you’re an SME in the UAE, there are a growing number of good options available. Check out our guide on UAE lending initiatives for SMEs to learn more.

 

How Can You Pay Your Debt Back?

 

Debt financing requires a healthy cash flow. Your company has to generate enough revenue to pay the debt back. Your company’s rate of return should be higher than the interest rate, otherwise borrowing money is a losing prospect. Swelling debt payments will also hurt your cash flow, choking off money for operations.

 

Is Debt Financing Tax Efficient ?

 

Another potential benefit is that debt is often tax deductible. That can lower the cost of borrowing. This however depends on the type of debt and how it’s used, so consult a tax professional.

 

Debt to Equity Ratio

 

When taking a loan, bear in mind that your company’s level of debt can affect its future  prospects. A key metric is the debt- to-equity ratio, a measure of a company’s reliance on debt. A high ratio can imply risk and scare off investors, while a very low one could suggest there’s ample room for growth via more debt.

 

 Is It Time For Equity Financing?

 

Suppose you don’t want to take on more debt. Perhaps it made good sense when interest rates were nearly zero. But sadly, those days are gone. Or maybe your cash flow isn’t strong, so the risk of default is too high to borrow. Now may be a good time to explore equity financing. In other words, you can raise capital by selling a stake in the company or issuing shares to investors.

 

Equity financing is a common strategy for startups. That’s unsurprising, given the difficulty they face getting loans. In the Gulf, equity financing is becoming more common. A growing number of private equity firms are even setting up shop.

 

Who exactly is buying into your company? That depends on how established you are. For startups, it’s often angel investors. Emerging businesses with strong growth potential may be able to attract venture capital funding.

 

Another good option is crowdfunding, which pools small chunks of money from large groups of investors. Crowdfunding has been on the rise in the Gulf amid regulatory reform.

 

Equity Financing Pros

 

There are considerable benefits to equity financing. Unlike debt, the money doesn’t have to be repaid. That preserves cash flow for everything else.

 

New investors often bring more than just their money. Small companies can benefit from their network too. Their specialized knowledge and skills can also be what’s needed to edge out stiff competition. Raising equity also signals confidence. If investors are buying in, your company must have a good story. New investors can raise your company’s profile and build hype around your product or service.

 

Finally, your company’s risk is shared. Investors don’t get paid unless the company makes money. Everyone has an incentive to make the business fly.

 

Equity Financing Cons

 

Equity financing entitles investors to a piece of your company. That means they get a chunk of the profits. If you sell the company, they get a percentage of the proceeds.

 

Perhaps the thorniest issue of all is loss of control. If an investor acquires a large enough stake, they get voting rights. Larger investors can push for new directors on the board or radical policy changes. In the most extreme case, they can mount a hostile takeover of your company, Gordon Gekko style – though that’s not very likely.

 

The more immediate concern is your company’s valuation. How much is it worth? In a bear market, investors may give your company a low valuation. That means you have to sell a bigger stake to get the same amount of cash. As we said at the start, money has a price, so how much are you willing to pay?

 

 

 

 

 

 

 

 

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