Equity Financing vs Debt Financing: What is the Difference?
So you’re planning to raise funds or have already done so and are thinking about how it fits into your accounting? Generally speaking, there are two types of funding or financing, as it were, namely equity financing and debt financing. Here we’re going to be exploring the main differences between the two types of financing. Very briefly, if a shareholder gives money to a company as capital, this is known as equity financing. On the other hand, if a company is provided with a loan, this would be considered debt financing.
It is common for companies to obtain a combination of the two, but each has its unique advantages. Mainly, equity does not need to be repaid by a company, so it’s considered as credit. On the other hand, debt is simpler to report and gives shareholders more flexibility if they want to get back the money they put in. Have a second to spare? Then, let’s take a deeper dive to learn more about the differences between debt financing and equity financing.
What is Equity Financing? What are the Pros and Cons?
Equity financing is the mode of raising capital by selling shares. Equity financing can come from various sources, such as but not limited to friends and family or new investors (private or public), for example. This type of financing is often opted for when a company needs a short-term cash solution.
In terms of reporting equity financing, if your company is given money in exchange for shares, this is known as share capital. It is reported as a credit amount given to the company, so it does not need to be repaid to the shareholder. It is possible to increase share capital later on. So if an existing shareholder gives more money to the company, not expecting to be paid back, it could be reported as additional share capital.
One upside of equity is that it does not place any financial burden on the company. Equity financing will appear as a credit in the books rather than a debt. As you can imagine showing green in the books can be helpful when trying to secure funding from a bank or other shareholders. Also, in the event the company doesn’t do as well as expected, the shareholders won’t expect repayment less risky somehow.
Another possible advantage of equity financing is the potential to grow the company’s network. Adding high calibre well-known investors with an extensive network could open doors for the company to grow, whether by attracting new investors or getting opportunities for mentorship, for example.
That said, there are some disadvantages to financing as equity, and they are not to be taken lightly. First, when share capital is given to the company in exchange for additional or new shares, part ownership is given away. Giving away part ownership entails giving some control away. In such a case, you’ll inevitably have to discuss business decisions with all the company’s investors. You will also be required to share profits with the added investors. Investors, a.k.a. shareholders, can be removed later but only by buying them out. Whereas buying out an investor can be more expensive than the original funds you acquired from them.
Note that if you receive equity funding at a later stage after incorporation, whether in exchange for additional shares or not, you’ll need to meet specific filing requirements at the IRD and/or Companies Registry. For example, you may need to:
Report increase of share capital; and/or
Report share allotment (i.e. creating new shares).
Your company secretary can help you with reporting but of course at a cost, and the process is not always so straightforward.
What is Debt Financing? What are the Pros and Cons?
As the name suggests, debt financing usually refers to when a company raises funds by borrowing money. Of course, borrowing means the amount raised eventually has to be paid back- usually with interest. Loans from a shareholder or a bank are some of the most common forms of debt financing. Depending on the agreement with the individual or corporate body loaning the money, some restrictions may be applied on the company limiting its activities.
One main advantage of debt financing is that, unlike equity financing, debt financing does not require the company to give away any ownership interest.
On top of that, if a shareholder gives a loan to a company, it gives them more flexibility. The reason for this is that with a loan, shareholders have the option to get reimbursed whenever the company has funds to pay the loan back. In addition, depending on the agreement between the shareholder and the company, some interest could be applied. Alternatively, a shareholder can even choose to waive their right to be paid back the funds, essentially giving the money to the company.
It could be argued that borrowing money from a shareholder poses minimal risk as a part-owner of the company as they may not demand repayment should hard times hit. However, if money is borrowed from a financial institution or other third party and the company faces difficulties or simply doesn’t do as well as expected, the company must bear the burden of meeting instalment payments following the set schedule agreed on prior. This could dampen the company’s growth.
Opposite to equity financing, debt financing will inevitably appear as a debt in the books, potentially negatively impacting cash flow and credit score.
Equity and debt financing both have their pros and cons; which one a company opts for really depends on its needs. But, generally speaking, a company can consider how the financing will affect its books (i.e. reporting), its cash flow; flexibility required; and how important it is for its principal owners to maintain control.
If you’ve already raised funding, hopefully, the above gives you a better idea of how to report it, whether as equity financing or debt financing in your accounting and with local Hong Kong authorities, where applicable.
On that note, do you need help with accounting, audit and/or tax filing? We can help!