Debt financing

Debt financing is the practice of selling bills, notes or bonds to individuals or institutional investors to raise funds for capital expenditures and working capital.

This contrasts with the other main way to raise funds: equity financing. This is when you offer shares of your stock as part of an initial public offering.

You can also use a combination of both debt financing and equity financing to get things up and running. It’s not an either or situation.

With equity financing, you’re giving up stake in your company but the good news is you don’t have to pay back the money. Obviously with debt financing, that’s not the case and you will have to pay it all back when you start turning a profit.

With debt financing, you take out fixed rate amounts of bonds, bills or notes in order to get the money you need to expand. The amount of the loan has to be paid back at the agreed upon date. If the company goes bankrupt, these debt financing lenders have high claim on assets ahead of shareholders, who are usually last in line.

Your company’s capital structure always be made up of debt and equity. It’s all about how you balance it. Equity goes to the shareholders and debt goes to the investors who gave you the bond, bill or note. When you take on debt, you’re not only agreeing to the full amount you’re borrowing, but also to the amount of interest that your lender can charge you over the life of the loan.

The total cost of equity financing and debt financing is what’s known as your cost of capital, which is the minimum you have to make in order to be able to pay all the people you owe and simply break even. Obviously, you’ll want to be doing a lot better than just breaking even though. If you’re not, then it’s high time you reevaluate your capital structure before things really start to fall apart.

EXAMPLE:

I don’t want to give up shares in my company but I also don’t want to pay interest. I’m at a bit of a rock and a hard place when deciding between equity financing and debt financing.

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