Bidur Prasad Lohani

A business organisation needs money to run itself. Financial activity is required to stimulate the growth of the business. But not every organisation has enough funding to run, grow, or launch a new product. Financing your business is a crucial part of when you want to start, expand or explore new opportunities for your business.

There are different ways of financing the business, you can get capital by sharing ownership in the business, you can borrow money from banks or other financial institutions, or you can invest money by yourself. But when did business financing start? Recorded instances of business financing date back to ancient times when Greek lenders funded miners, shipping concerns, and constructors.
Business financing is either long-term or short-term. Short-term financing is used for working capital and other short-term needs whereas, long-term is used for long-term initiatives, risk management, and upgrading facilities.

Equity
Equity is the ownership of the business that includes every asset along with debts or other liabilities attached to them. Let's say you and I started a business and we have equal shares of the business, then we create shares of equity which can also be called stock. For instance, each of us has 50 shares of equity totaling our shares to 100, where each of us owns 50% of the business. Now, we decided to grow our company and needed money. We found an investor and we agreed to sell 25 shares to him for his $1 million investment.
Now, what happened is our total shares went up from 100 to 125. Since you and I have 50 shares each, we now own 40% (50/125) of the business totaling 80% whereas, our new investor owns 20% (25/125) of the business.

This is how we get funding through the use of our equity. You may think that issuing new shares is the best way to fund your business, but it's not as easy as you might think. When you issue new shares the existing stockholders' ownership percentage of that company will decrease. From the above example, we can see that our ownership percentage had decreased from 50% to 40% each when we issued new stock, this is called dilution. When the number of outstanding shares increases, each existing stockholder will have a low percentage of ownership of that company, making each share less valuable. So how does dilution affect you and your business? The answer is you may lose the control that you used to have of the business when the stocks are diluted.

It is because your ownership percentage is also decreased. This not only lessens the financial benefit that you get but also weakens the voting right that you used to have. To mitigate the problem of a reduced voting right, the company often uses classes of shares. For instance, Google has three classes of shares: class-A, class-B, and class-C. Class-A shares are held by a regular investor with regular voting rights, class-B shares are held by the founders with 10 times the voting power compared to class-A shares, whereas class-C shares have no voting right. So, this is how they maintain control over their company without compromising their growth.

The potential benefit of equity is that it does not need to be repaid like a debt which reduces the burden for you and it could result in resourceful partners and advisors. A potential drawback of equity is you need to share profit, sharing ownership may result in a conflict or you may lose control of your business. If you are an independent solo operator, then debt might be better than equity for you.

Debt
Debt simply means the money borrowed by one party from another. Debt can be very useful for a company to grow rapidly. For instance, if you had assets of $10 million and earned $1 million your company's Return on Assets (ROA) would be 10% (as ROA = Earning / Total Assets) and if you had invested all the earning in the company, it will result to Internal Growth Rate of 11.1% [as Internal Growth Rate = ROA * b / 1 - (ROA * b)]. Here b is the retention rate which will be one if all the income is retained to grow the business.

This is the maximum possible growth rate of your company without debt. Now if we took a debt of $500,000, our total earning will be $1.5 million ($ 1 million earning + $500,000 debt) and assets will increase to $10.5 million. This will result to the ROA of 14.28% and if all the earning is retained to grow the business our Internal Growth Rate will increase to 16.66%. Basically, the borrowing has boosted the Internal Growth Rate of the company by 50%.

This is the power of debt. One vivid benefit of debt is: it is tax-deductible. To give you an example if our company earns a profit, we would have to pay tax for it and when we distribute these profits to its owners, they do need to pay taxes for their personal dividend earnings, this is called double taxation of dividends.
If instead the firm finances with debt, and the firm owes the same amount as of profit to investors, then they won't have profit for taxation so no tax on profit.

The only tax paid is by investors for their interest income. In conclusion, what debt has done is it has reduced the amount that a business and investors had to pay as a tax.
According to Statistica, the debt of non-financial corporations worldwide in the first quarter of 2008 was 46.63 trillion U.S. dollars, now as of the 3rd quarter of 2020 it is 81.01 trillion U.S. dollars. These statistics clearly show around a 75% increase in corporate debt. You can finance debt either by taking a loan or issuing a corporate bond.

A corporate bond is issued by a firm and sold to investors and it can also be sold on the bond market. Debt can help you grow your business faster, however, there are some financial risks and challenges associated with it. If you carry a high level of long-term debt then you need to repay the debt which will decrease the earnings. And with that limited earnings you cannot invest or save money for future expansion as before.

Moreover, if there is any unfavourable market fluctuation or decrease in your product sales it will be very hard for you to pay the loan together with wages and overhead costs. If you start missing loan repayments, your business may lose credibility and it will be difficult to persuade lenders to issue you a new debt.

Right Balance
Ultimately, if the business becomes incapable of paying the debt, it may lead to bankruptcy of the business. But no need to be anxious, if we keep the right balance between debt and equity, we can grow the company to its maximum potential without risking the business.

In short, if you choose equity, you can get resourceful partners and freedom from repayments, but with a decrease in ownership reducing the share of your upcoming profit and control. Conversely, if you choose debt, you could increase the potential growth rate of your company without losing your control and ownership, but having to pay it back with interest. Choosing between debt and equity is subjective, so it depends on you and your interest.

If you don't want to dilute ownership, and you are pretty optimistic about the future of the business, then it's better for you to choose debt. Conversely, if you want a partner who can add value to your business, or you are a little pessimistic about the future value of the business, equity is a great option.

(Campus Director at HULT Prize Foundation, Lohani has conducted research in finance, business and technology)