Debt versus equity financing: key differences and trade-offs

Capital

There are a number of financing options for small business. The two major categories are debt and equity. Debt comes in a variety of forms. Bank loans are common. Credit cards are used sometimes by startups; bond issues by larger firms. Debt is an attractive option for a number of reasons. Debt has a lower cost of capital, which is beneficial to many small businesses. As well, debt financing allows the owners of the company to maintain control, and this is usually considered to be quite important for many small businesses in particular. The downside to debt is that the company is then obligated to pay that debt back before it can reinvest profits back into the business - debt repayment is more important than reinvestment in terms of financial obligations (Parker, 2012).

Equity comes at a higher cost than debt. Equity is also means that some control is given over to new shareholders. It can be more difficult to raise equity capital as well, for small businesses and significant amounts of equity capital will usually mean that some control over the company is ceded. The upside of equity is that it comes with no immediate cost -- there is no money that is repaid and therefore compared with debt financing, equity financing allows the company to reinvest all of its profits back into the company and its growth.

No matter which form of capital is chosen, if the company needs to go to market it should work with an investment banker. There are a number of factors that should be taken into consideration when selecting an investment banker. They come at different costs, and the company needs to weigh the costs and the different things that different investment bankers might bring to the table. In general, the track record of the investment banker bringing financing to market is important, because the company is going to want to maximize the value it gets from this service -- the more money it can raise for a level of control on an equity issue is important. Experience is important, because the investment banker needs to be able to close the deal. The support team is important because the investment banker is a comprehensive service. Furthermore, you have to have a high level of trust and work well with the investment banker in order to have the comfort level with this very important business relationship that might well define how the company moves forward (Mahmood, 2013).

Risk and return are related in the long run. Essentially, investors are risk averse and will take the lower risk security among options of equivalent returns. Thus in an efficient market, the expected return on a security relative to its price will reflect the perceived risk of the security. In an efficient market, the risk-return relationship will always hold.