Title: Financing 101 — How Companies and Individuals Raise Capital, Compare Options, and Choose the Right Mix
Source: Investopedia — “Financing” by Theresa Chiechi (https://www.investopedia.com/terms/f/financing.asp)
Overview
Financing is the process of obtaining money to fund business operations, purchases, investments, or personal needs. Two broad methods exist: debt financing (borrowing) and equity financing (selling ownership). Each method has trade-offs in cost, control, risk, and flexibility. Most businesses use a mix of both and manage that mix with measures such as the weighted average cost of capital (WACC).
Key takeaways
– Debt: must be repaid, often cheaper (after tax) and preserves ownership, but increases default/bankruptcy risk and may impose covenants.
– Equity: does not require repayment and shares risk with investors, but dilutes ownership and may give investors control or influence.
– Optimal capital structure balances cost (WACC), risk tolerance, and strategic objectives.
– Financing decisions should be driven by cash-flow forecasts, expected returns on funded projects, and long-term strategy.
Understanding the two main types of financing
1) Equity financing
Definition: Raising capital by selling shares/ownership stakes or bringing in partners/investors.
How it works: Investors give money in exchange for a claim on future earnings and usually some governance rights (voting, board seats, voting rights tied to shares).
Advantages of equity financing
– No mandatory repayments or interest obligations.
– Lowers bankruptcy/default risk because cash flows are not tied to fixed debt servicing.
– Investors may contribute strategic value (expertise, networks).
– Useful for early-stage firms that cannot access debt or for high-risk investments.
Disadvantages of equity financing
– Dilution of existing owners’ control and claim on future profits.
– Potential conflicts with new shareholders (strategic direction, payouts).
– Often more expensive in the long run because investors expect higher returns than lenders.
– Fundraising takes time and often requires disclosure and governance changes.
2) Debt financing
Definition: Borrowing money to be repaid with interest over time; may be secured (collateral) or unsecured.
How it works: Lenders provide funds with contractual repayment schedules and may impose covenants (financial or operational restrictions).
Advantages of debt financing
– Interest is generally tax-deductible for corporations (lowers after-tax cost).
– Does not dilute ownership or control.
– For established firms with predictable cash flows, debt is often the cheaper source of capital.
– Flexible forms (bank loans, bonds, asset-backed loans, lines of credit).
Disadvantages of debt financing
– Mandatory interest and principal repayments can strain cash flow, especially in downturns.
– Collateral requirements and covenants can limit operational flexibility.
– Excessive leverage increases bankruptcy risk and raises the cost of future financing.
Special considerations
– Tax treatment: Interest is typically tax-deductible; equity returns (dividends, capital gains) are not deductible for the firm.
– Covenants and collateral: Restrictive covenants (e.g., limits on additional debt) and pledged assets can constrain management.
– Stage of company: Startups often need equity (or convertible instruments) because debt markets require predictable cash flow or collateral.
– Market conditions: Interest rates, credit availability, and investor sentiment influence cost and feasibility.
– Non-financial value: Strategic investors can add know-how, customers, or distribution access.
– Signaling: Choosing equity or debt can signal management’s view of firm prospects to the market.
WACC — how firms evaluate the combined cost of finance
WACC = (E / V × Re) + (D / V × Rd × (1 − Tc))
where:
– E = market value of equity
– D = market value of debt
– V = E + D (total financing)
– Re = cost of equity
– Rd = cost of debt
– Tc = corporate tax rate
Example WACC calculation
Assume:
– Equity value E = $750,000
– Debt value D = $250,000 (so V = $1,000,000)
– Cost of equity Re = 12%
– Cost of debt Rd = 6%
– Corporate tax rate Tc = 21%
WACC = (750/1000 × 12%) + (250/1000 × 6% × (1 − 0.21))
WACC = 0.75×0.12 + 0.25×0.06×0.79 = 9.0% + 1.185% = 10.185%
This shows how adding cheaper debt (and its tax shield) can lower overall cost of capital up to the point where increased default risk offsets those gains.
Practical example: debt vs equity for a small-business owner
Scenario: You need $40,000. Options:
– Debt: bank loan at 10% interest, 1-year for simplicity → interest expense = $4,000.
– Equity: sell 25% of your business for $40,000.
If the business earns $20,000 profit next year:
– With loan: profit after interest = $20,000 − $4,000 = $16,000 (100% to owner).
– With equity: owner retains 75% of profit = $15,000.
Result: debt produced a higher residual for the owner that year. But this ignores taxes, loan amortization, investor expectations of future growth, and long-term strategic considerations. Equity transfers future upside and control; debt increases fixed obligations.
Is equity riskier than debt?
– For investors: equity is generally riskier because investors are residual claimants—paid after debt holders—so in bankruptcy they are last to receive value.
– For the firm/owner: issuing equity reduces bankruptcy risk (no fixed payments), but can be more expensive (higher expected return demanded by investors) and dilutive to control.
– So equity is riskier for the capital provider; debt can be riskier for the company’s survival if overused.
Why a company would choose equity financing
– Early-stage firms without steady cash flows or collateral.
– Large growth initiatives where cash flow volatility is high.
– When an investor brings strategic benefits (expertise, distribution).
– To reduce leverage and improve balance-sheet strength.
– To avoid restrictive covenants or short-term cash commitments.
Why a company would choose debt financing
– Predictable cash flows that support repayments.
– Desire to retain ownership/control.
– Lower after-tax cost (interest tax shield).
– Short-term or asset-specific funding where collateral exists.
– To leverage return on equity when returns on projects exceed cost of debt.
Practical steps to choose and obtain the right financing
1. Define the financing need precisely
– Amount, purpose (working capital, capital expenditure, acquisition, refinancing), timing, and duration.
2. Build realistic cash-flow forecasts
– Project cash inflows and outflows for the loan term or investor horizon to assess repayment ability or dilution impact.
3. Estimate cost of capital alternatives
– Get interest quotes and estimate required investor return (use comparable exits, required rate of return).
– Compute impact on WACC and owner returns.
4. Assess non-financial trade-offs
– Control dilution, governance changes, strategic value of investors, covenants, reporting requirements.
5. Consider stage and risk profile
– Startups often seek equity; established firms typically blend debt and equity.
6. Examine structure options
– Debt types: term loans, lines of credit, bonds, asset-backed loans, convertible debt.
– Equity types: common shares, preferred shares, venture capital, private equity, strategic investors.
7. Prepare documentation and pitch
– Financial statements, business plan, projections, collateral schedules, investor pitch deck, term sheets.
8. Shop the market and negotiate terms
– Solicit multiple lenders/investors, focus on effective cost (interest, fees, covenants, dilution, liquidation preferences).
9. Close and integrate
– Ensure legal documentation, covenant understanding, governance adjustments, and use of proceeds match plan.
10. Monitor post-funding
– Track covenant compliance, use of proceeds, performance vs plan, and prepare refinancing or follow-on rounds ahead of need.
Checklist before final decision
– Can cash flows reliably meet debt service if borrowing?
– Would giving up equity negatively affect control or future strategic options?
– Is the expected return on the funded project higher than the effective cost of capital?
– What are the tax impacts (interest deductibility vs. no deduction for dividends)?
– Are there strategic non-financial benefits from potential investors?
– Is the market appetite favorable for the chosen instrument now (rates, investor sentiment)?
Examples by use case
– Early-stage startup: preferred equity or convertible instruments with venture investors.
– Growth-stage firm with scaleable revenue: mix of mezzanine equity and bank debt to preserve upside.
– Asset purchase (equipment, vehicle): secured loan or lease using the asset as collateral.
– Mature corporation financing an acquisition: combination of bonds, bank loans, and equity to optimize WACC and preserve credit metrics.
The bottom line
There is no one-size-fits-all answer. Financing choices depend on cash-flow predictability, tax position, control considerations, the firm’s stage, and market conditions. Thoughtful analysis—forecasting, cost-of-capital comparisons, and an eye on strategic outcomes—will identify the combination of debt and equity that best supports the business objective while managing risk.
Further reading and source
This article is based on concepts and explanations from Investopedia: “Financing” by Theresa Chiechi (https://www.investopedia.com/terms/f/financing.asp).
If you’d like, I can:
– Build a one-page financing plan for a specific business scenario (give me projections and funding needs).
– Run a simple WACC and owner-return comparison using your numbers.
– Draft a term-sheet checklist for either a debt or equity raise.