Cracking your head thinking about what is the best way to finance your business? Find out here what are the risks of debt and equity financing!

There are generally two ways to finance your business – debt and equity. Debt financing is the loan that you borrow from the bank while equity financing involves issuing or selling your shares to other investors. Both have their pros and cons respectively.

You should be completely clear on the risks of using debt or equity in your business as it could determine whether it will be successful or not. Read more below on what are the three risks of debt and equity financing respectively.

Debt Risk #1: Mandatory Interest Payment

Taking a loan or debt from the bank means instead of paying up a lump sum, you can make a big purchase while making your payments in regular monthly intervals. However, be aware that splitting your loan repayment into monthly installments, while not as hefty and significant as a lump sum, can still pose a risk to your cash flow.

Typically, when you take up a loan to fund a project, it will take some time before the business is able to generate revenue and cash. It is that period of time when you will be tight on cash and you will still need to pay the interest on the loan.

As a business owner, you would already be maintaining cost of business expenses such as employee salaries, rent, software licenses, and various other costs also. Adding on a monthly high-interest payment could interfere with your ability to pay for these other business expenses.

If your ability to pay up is threatened, the risk here is losing something you are unable to pay for but yet is very necessary for your business to operate, whether it is your premise (since you are unable to pay rent), employees (why continue working if you can’t pay their salaries), or other resources.

Do calculate wisely whether your business can sustain business expenses while waiting for revenue to roll in.

Debt Risk #2: Losing Your Collateral

For your business to be granted a loan, the bank would normally need collateral assets from you. Doing so provides the bank with an insurance or backup plan in case you can’t afford to repay the loan, and they could then take possession of your collateral and sell it to recoup their loss.

Typically, if you have assets that are worth a lot, you can qualify for a higher loan amount by pledging these assets as collateral. This enables you to take on bigger projects that could generate higher profits for your business.

However, higher returns equate to higher risk. You would need to offer something in your possession that is important such as property, car, or any other assets. While banks do not simply take possession of your collateral unless they are forced to, losing it could disrupt your personal and family life and significantly reduce your standard of living.

Debt Risk #3: Bad Credit Rating

Losing your collateral will only be the start of the problem. Defaulting on business debts could worsen your credit rating and prevent your business from taking up future loans.

Maintaining a good credit rating is important as banks would evaluate your credit profile whenever you apply for a loan. A bad credit rating is flagged as risky and banks would increase the interest rate and repayments should you apply for a loan with a bad credit rating.

Even when your business has a solid project or investment to undertake, it could fail to take off if the interest rate is too high or you can’t get a high enough loan amount. It becomes more crucial to undertake new investments when you failed in your previous ones, as your business needs to recoup the losses to stay in business.

You need to be aware that people tend to remember the negative aspects more vividly and a bad credit rating is no different. It could be the case that your business is increasingly profitable but banks would still regard your bad credit rating in the past as a dominant factor in whether to lend to you or not.

Equity Risk #1: Losing Ownership and Control of Your Company

When you issue or sell your company shares to external investors, you can raise funds for your company without putting up a collateral asset as you would do for bank loans. You also do not have to pay any interest as it is up to you whether you want to give out dividends to yourself and investors.

However, you do lose control and ownership of your company if you rely too much on equity financing. As more and more investors enter your company, you have to increasingly accommodate the different viewpoints and visions of different investors. Decisions are harder to pass and approve, and the vision of the company might change.

Worse comes to worst, you could be removed from the company if other investors band together, buy your shares out, and remove you from the company.

Equity financing is great if you use it sparingly without losing significant control. You should always ensure that you maintain at the very least 51% ownership of the company so that you have majority voting power on the board.

Equity Risk #2: Lower Profits/Dividends for Yourself

When the company is generating a lot of revenue and profits, you can reap the benefits by issuing dividends to yourself and other investors. However, as your ownership of the company decreases, the profit that is attributable to you decreases as you would need to share the profits with other investors also.

You would not be able to reap the maximum profits compared to when you have full ownership of the company. This is troubling if the company generates a record amount of profits due mainly to your efforts and vision in leading risky projects and investments. However, you need to balance this with the fact that you need funds from other investors in the first place to actually be able to undertake risky projects.

Equity Risk #3: Higher Regulatory and Disclosure Requirements

Financing with equity comes with more risk compared to getting a loan. An investor who is interested in your company would want to know in detail what your company is about, your vision, and its future prospects. Hence, regulators actually require companies to properly disclose information to investors and ensure they are well-informed on their investing decisions.

To prepare such information for disclosure, you would need to spend quite a bit of money to hire the appropriate consultants, legal team, or even bankers to arrange such a deal. Furthermore, you would need to clean up your financial accounts so that you don’t get into trouble with the authorities. The authorities may also conduct an audit on your company from time to time when you issue shares to get financing.

Conclusion

Financing your business through either debt or equity comes with its own unique risks. It is important for you to determine what are the best ways for you to raise funds from the banks or investors, to ensure that you maximise the potential of your company without sacrificing too much ownership and putting your assets at risk as collateral.

 

Let us know in the comments below the measures you are taking to mitigate your risks.

 

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