Why equity is costlier than debt

This means the effective cost of the borrowing is less than the stated rate of interest. Essentially, the US government helps mitigate the cost of your loan. Taking on equity investors means giving them seats on your board. It also means conforming to their expectations of how your company should grow. No board seats, no control. The extra cash will let you make a few key hires. If you hire well, those folks will build out features and sales programs and you can see an ROI much higher than the cost of their salaries.

Raising a VC round usually takes between six and nine months of coffee meetings, pitches, and phone calls. Every business needs capital to operate successfully.

Capital is the money a business—whether it's a small business or a large corporation—needs and uses to run its day-to-day operations. Capital may be used to make investments, conduct marketing and research, and pay off debt. There are two main sources of capital companies rely on—debt and equity.

Both provide the necessary funding needed to keep a business afloat, but there are major differences between the two. And while both types of financing have their benefits, each also comes with a cost. Below, we outline debt and equity capital, and how they differ. Debt capital refers to borrowed funds that must be repaid at a later date. This is any form of growth capital a company raises by taking out loans.

These loans may be long-term or short-term such as overdraft protection. Debt capital does not dilute the company owner's interest in the firm. But it can be cumbersome to pay back interest until its loans are paid off—especially when interest rates are rising.

Companies are legally required to pay out interest on debt capital in full before they issue any dividends to shareholders. This makes debt capital higher on a company's list of priorities over annual returns. While debt allows a company to leverage a small amount of money into a much greater sum, lenders typically require interest payments in return.

This interest rate is the cost of debt capital. Debt capital can also be difficult to obtain or may require collateral, especially for businesses that are in trouble. Because payments on debts are often tax-deductible, businesses account for the corporate tax rate when calculating the real cost of debt capital by multiplying the interest rate by the inverse of the corporate tax rate. Reasons Not to Give Away Equity.

Reasons Why Debt is Best. Part 4: How does Venture Debt Work? If you would like to read more about the repayment terms, you can skip ahead to part four of the guide here. Interest payments are relatively low, so for a debt fund to lend, loans are subject to lite covenants and secured by shareholder guarantees. The bottom line is this. It can take months to secure equity investment. In other words, the more profitable a company is or will be, the more costly it is to sacrifice equity, as it is more beneficial for an owner to simply keep the profits and pay interest.

Given the higher risk that equity holders have in losing everything they invested should a company fail, equity holders would generally demand a greater return to compensate them for taking on this additional risk. There are limits however to the amount of debt lenders will typically allow, as the higher amount of debt a company carries the higher the risk the company may default. As such, after a certain level of debt it may be unlikely for a company to take on additional debt because the company will be over-leveraged, or the cost of additional debt will be substantially higher to compensate the lender for taking on this additional risk.

In summary, although debt is generally a cheaper source of financing compared to equity, this is not always the case and will depend on the financial stability and circumstances of the company.