Businesses and other entities can finance their enterprises by issuing equity or using debt, such as borrowing funds through loans or by issuing notes. Unlike equity, debt has a specified interest rate and a schedule of dates when interest is to be paid and all the principal fully repaid.
Many fast-growing companies would prefer to use debt to support their growth, rather than equity, because it is, arguably, a less expensive form of financing (i.e., the rate of growth of the business’s equity value is greater than the debt’s borrowing cost). But there must still be sufficient operating cash flow generated by the enterprise to “service” the debt’s interest and principal payment obligations, or there could be severe consequences for the business, as noted below.
Reasons why companies might elect to use debt rather than equity financing include:
- A loan does not provide an ownership stake and, so, does not cause dilution to the owners’ equity position in the business.
- Debt can be a less expensive source of growth capital if the Company is growing at a high rate.
- Leveraging the business using debt is a way consistently to build equity value for shareholders as the debt principal is repaid.
- Interest on debt is a deductible business expenses for tax purposes, making it an even more cost-effective form of financing.
- Debt can be somewhat less complicated to arrange than equity financing and may not require shareholder approval.
- There is a broad universe of lenders that specialize in various industries, stages of business and types of assets.
- Once the debt is repaid, it’s gone. Equity remains outstanding unless repurchased by the Company, which typically requires the shareholder’s consent.
Debt can be used to finance a wide variety of business activities including working capital (to acquire inventory, for example), capital expenditures (such as to finance equipment purchases) and acquisitions of other companies, to name a few. The term or maturity of the indebtedness should generally match the period associated with the assets being financed. For example, inventory, accounts receivable and other short-term assets are usually financed with short-term debt that is less than one year in maturity. Equipment loans are normally three years or longer, and mortgage loans financing real property are typically 15 years or longer since those assets have longer useful lives for the business.
From the borrower’s perspective, debt has a fixed cost, the interest rate, but it represents a significant potential threat to the company’s existence. If interest and principal are not paid as agreed, lenders can foreclose, possibly requiring the business to cease operations and liquidate its assets. Issuing equity, on the other hand, results in sharing future profits with investors but is less threatening to the future of the business if profitability becomes impaired.
Debt is senior in liquidation preference to equity when a company’s assets are sold, reducing the amounts available to equity investors from any asset sales, forced or voluntary. Though not obliged to do so, lenders may agree to restructure a non-performing loan by agreeing to forebear which often extends the maturity of the loan, possibly with the accrual of interest due to lenders, albeit normally at a higher interest rate.
From the investors’ perspective, debt investments are also known as fixed income investments since interest and principal payments are scheduled and are anticipated after the loan or note investment is made. Equity investments, on the other hand, produce varying levels of return depending on the profitability of the Issuer over time.