equity, debtIt seems like a no-brainer to me to take debt-based options over equity-based financing.
Is there an objective way to decide between the two? Furthermore, what are the advantages and disadvantages of each?
It seems like a no-brainer to me to take debt-based options over equity-based financing.
You haven’t said why you consider debt to be more preferable than equity finance—but one presumes it is some combination of:
control is not shared with a lender (whereas equity investors with whom one may not always agree might exercise significant control over the business). However, lenders may require certain covenants (i.e. contractual promises) that in reality restrict your freedom to control the business as you wish: for example, a bank may insist that there be no change of ownership or strategy so long as its debt remains outstanding; or they may require that certain performance targets be met.
profits are not shared with a lender (whereas equity investors take a slice of everything you make). However, the cost of debt finance (i.e. interest charges) does in fact reduce the business’s profits; furthermore, it should not be ignored that because they don’t share in the profits (nor are they exposed to as much risk), lenders have relatively little incentive to see the business succeed—thus equity investors will often go much further to help than a lender (and such help can be invaluable, especially during a startup’s early years).
interest payments on debt are tax-deductible (whereas dividends to equity investors are not). However, this is only a benefit provided that the profits are reinvested in the business’s growth: as soon as the profits are distributed to shareholders, tax must be paid.
upon repayment of a loan, relationships with lenders draw to a close (whereas one can be stuck with equity investors for a long time). However, in reality, one very often continues those relationships over multiple financing rounds (and walking away from such a key relationship can be difficult without raising concerns from future investors).
debt is a relatively cheap source of finance (whereas equity investors expect a much higher return and thus take a much more costly share of the profits). However, debt capital must be repaid with interest (which might be calculated at an unpredictable, variable rate); any breach of these or other covenants could ultimately lead to the business being wound up.
debt enables an equity investment to be geared-up. However, a leveraged business is more vulnerable should it fall upon tough times; indeed, shareholders will recognise this risk and be less willing to provide further equity finance to a highly geared business. Furthermore, ensuring that covenants are not breached may stifle growth.
It’s also worth bearing in mind that lenders may demand a charge over business assets or even personal guarantees that may be called upon in the event of default; whereas shareholders usually accept that their investment is higher risk and are willing to write-off their losses in the event of failure.
Is there an objective way to decide between the two?
It is a trade-off between risk and return. There is no objective way to decide something that boils down to the personal risk appetites and cashflows of the shareholders involved: the exact same business could be entirely financed by equity (if backed by an investor with a low risk appetite but sufficient cash) or entirely by debt (if backed by an investor with a high risk appetite or insufficient cash).
In reality businesses tend to be financed by a mix of the two, according to the risk appetites and cash resources of the investors involved.
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