Debt Financing vs Equity Financing: The Ultimate Guide [2022]

Deciding on whether to go with debt financing or equity financing can be a pivotal decision that could change the course of your business’ future.
debt financing vs equity financing

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When raising capital for a business, companies usually have two options: debt financing vs equity financing. While some companies choose to go for both, it should be known that there are advantages and disadvantages to both. Fundamentally, equity financing carries no repayment obligations, while debt financing requires giving up a portion of ownership.

Deciding on whether to go with debt financing or equity financing can be a pivotal decision that could change the course of your business’ future. For small businesses in Singapore, now is looking to be a good time to amass funds for company expansion. 

The overall economic outlook in Singapore is looking to be gaining traction, corporate tax rates are still steady, and the government is pushing for institutional lenders to make financing more accessible to SMEs.

When raising funds, it is imperative that all SME owners should decide on  the type of business financing that is appropriate. Options are usually narrowed down to either debt financing vs equity financing.

Equity Financing Definition

Equity financing requires giving up a portion of company ownership in exchange for working capital.

The main advantage of equity financing is that there is no repayment obligation. Instead of repayment, investors are looking for returns on their invesment in the longterm. Therefore, there is no financial burden on the company and there will be more capital to invest in growing the business.

However, there are downsides. Where a portion of ownership must be given up, you will have to share profits with the investor forever. On top of that, you may also have to consult with the investors everytime a major decision has to be made. The only way to get rid of investors is to buy them out eventually, which can be very costly.

Debt Financing Definition

Debt financing is the borrowing of capital in exchange for repayment with interest. The most common form of debt financing is a business loan, where banks or financial institutions will scrutinize the financial strength and credibility of both the company and its owners.

The good thing about most business loans as working capital is that they come with no restrictions. You are able to use the working capital as you deem fit. And when the business loan is repaid, there are no more obligations to the lender.

However, there are downsides. There will be a significant financial burden where you have to repay monthly installments. Therefore, there will be a need to ensure that your company’s cash flow can meet the installment amounts. Another downside is that the directors of the company will also hold personal liability as most debt financing instruments will require for the director(s) of the company to guarantee the business loan.

Below are some things to know about business loans and other debt financing options.

Why SMEs Choose Debt Over Equity Financing

If you’re looking for ways to fund your business expansion, you have two options. Debt finance or equity financing.

Equity financing entails selling shares of your company to outside investors in exchange for business, the value of which is normally defined by a mutually agreed-upon business valuation.

In Singapore, most businesses would seek debt financing through SME loan applications.

Here are some of the reasons why SMEs use debt to fund their working capital and expansion.

No dilution of ownership

You can sell shares of your company to investors through equity financing. Investors become co-owners of your business in exchange for the capital they put into it. The amount of co-ownership varies based on the amount of money invested and the business’s value.

You don’t give up control of your business when you take out a loan. You take out a loan and just pay it back with interest according to the conditions of the loan arrangement.

Some banks may typically require appropriate security in the form of property, equipment, or receivables. Many banks offer unsecured loan options for SME financing.

Less time spent waiting

A business loan might take anywhere from two weeks to a month to be authorized, depending on bank credit standards, requested loan size, and other factors.

Equity financing takes a lengthy time. Closing a deal with investors, including the necessary due diligence investigations and pitching presentations to potential investors, might take months. These could take away from the time you have set aside to manage your business.

Complete operational command

In the case of equity financing, new investors may request a board seat as a director and have a say in how the business is run. The board will now have to approve all business decisions.

If you want to test or accept a new business idea, you may need to get the approval of everyone who is involved in the business.

Creditors have no say in how your business is run when you use debt financing. Their main concern is that the business repays the loan as soon as possible.

Increased accessibility

Banks and other financial institutions work with a broader spectrum of businesses. Small and large businesses alike can benefit from a loan.

Investors, on the other hand, seek organizations with tremendous scalability and explosive development potential. Small traditional brick and mortar businesses, despite their established profitability and stability, rarely stand a chance with such investors.

In Singapore, various banks are participating in the SME banking sector. As a small business, it’s easier to get a loan through a bank’s vast consumer touch points than it is to approach VCs and pitch for money.

Although banks with retail locations are conveniently accessible, there is no guarantee that your loan applications will be approved. As a result, you must understand how to increase your loan acceptance prospects.

Positive credit history impact

Obtaining debts and repaying them on time has a beneficial impact on your credit score.

Maintaining a good payment history for debt you’ve accumulated will increase your chances of receiving a loan top-up offer and further financing with better terms.

Deductible from taxes

All business loan interest is tax deductible and can be included in your profit and loss statement.

The interest you’ve paid will be deducted from your company’s earnings before taxes as a tax deductible business expense. As a result, the amount of income liable to tax is reduced, resulting in cost savings for the business.

The Dangers of Debt Financing

By default, all unsecured business loan facilities demand a personal guarantee from the business owner (PG). If you default on a loan, you risk the banks exercising the PG, and in the worst-case scenario, you might face bankruptcy.

Most equity financing transactions are arranged without the need for PG, and the business owner’s risk is often limited.

Enterprise Singapore shares some risk with banks via government financing schemes like the SME Working Capital Loan, but the borrower is still liable and responsible for timely loan repayments.

Penalties for Late Payments

Penalty costs may apply if payments are missed. Late payment penalty is generally a connected loan cost and charge that most SME owners overlook to look out for.

A loan default event is classified differently by different banks and financial entities. The terms of your loan deal define what constitutes a default.

While various creditors may characterize a default event differently, one thing they all have in common is that they always incur penalties for late payments. Late interest is also levied, and it is normally a percentage higher than the loan’s interest rate.

A borrower who is 90 days or more behind on payments is considered a major event of default by most banks.

What Happens When There is a Default?

When a borrower defaults, creditors will send a notice to the borrower (based on the provisions of the loan contract). The first communication will almost certainly be a brief reminder urging early payment of previous dues, including late fees.

The second and future notices will most likely be similar, but will include a stern directive to settle obligations, as well as a reminder of the risks of default and potential legal action.

Even if the defaulted loan falls under government financing schemes like the Temporary Bridging Loan with certain percentage of risk sharing by the Enterprise Singapore, the borrower will still be legally liable for the full loan amount outstanding.

When Should the Issue be Discussed?

Talk to a loan officer at the bank immediately away. Allowing late fees and interest to build is not a good idea.

Other choices include loan restructuring, but be prepared to pay a considerable percentage of the past due obligation before banks provide any loan restructuring proposals.

Rights of the Lender in the Case of Default

In this instance, one of the lender’s alternatives is to foreclose on the asset you’ve mortgaged or assigned as collateral for the loan. If your loan is secured by real land, machinery/equipment, accounts receivable, or a bank account, anticipate your lender to recover the default amount (including interest and penalties) through these mortgaged assets.

In the case of a failure or foreclosure, the security documents and the loan contract you signed contain clauses about recovery rights.

If your loan is backed by a real estate mortgage, for example, the lender can foreclose on the property. The lender will eventually sell the property to recoup the unpaid loan amount. If there are no other liens on the property, any excess cash from the sale goes to the borrower.

How Does A Personal Guarantee Help A Business Loan?

A personal guarantee does not form a lien against a specific business asset.

Personal guarantees are divided into two categories. If you sign an unlimited personal guarantee in behalf of your lender, the lender can take over your personal assets and fully collect the debt, including all associated charges.

A limited personal guarantee, on the other hand, permits the lender to pursue assets up to the amount mutually agreed upon in the guarantee contracts. This is usually the original loan amount given to the borrower.

Most banks will seek personal guarantees from key directors or big owners, with the liability capped at the principal amount of the unsecured business loan issued.

Even with personal guarantees, banks are unable to foreclose on some assets, including as CPF balances and HDB flats.

If the guarantors are unable to provide any personal assets to offset the outstanding business loans, the banks may pursue bankruptcy procedures against them.

Number of Bankrupts Rising in Singapore

According to Ministry of Law statistics, the number of bankruptcy applications climbed for six years in a row from 2014 to 2019. However, in 2020, the number of bankruptcy applications fell to 2833, reversing the trend. This is most likely due to debt moratoriums issued by the government in response to Covid-19’s economic impact.

There are no specific statistics on the actual causes for bankruptcy filings, but CCS (Credit Counselling Singapore) stated in this Straits Times story that roughly 22% of debtors cited business difficulties as a major reason for entering bankruptcy.

Joint Guarantees

If you have other business partners, you will almost always need to provide personal guarantees for unsecured business loans.

If a business loan has more than one guarantor, the joint and several guarantee signed by all guarantors binds all legally culpable parties to the outstanding business loan in the event of a default.

Some business owners believe that if a firm has two directors who both provided personal guarantees on a company loan, the loan’s responsibility is split equally by both guarantors. This is not correct.

A joint and several guarantee agreement gives the bank the legal authority to sue any guarantors for the full amount of the outstanding loan if the company defaults.

Avoid Loan Defaults

Don’t take on more than you can handle. Check your numbers again to make sure you’re not taking out a larger loan than you need, especially if you’re applying for various bank loans at the same time.

Make debt repayment a top priority. Put off making unneeded business purchases. Your bills should come first, and your goal should be to pay off all loan payments on time to maintain your credit score.

Do not give up speaking and negotiating with your creditors before throwing down the towel. This is a difficult task, but do your best to come up with some reasonable repayment options that all sides can agree on.

Unsecured Business Loans

Amongst many assessment factors, here are a few major factors that most institutional lenders look at when deciding whether to lend money to a company – revenue, assets, creditworthiness and cash flow.

1. Revenue

This refers to the total amount of income into the business on a year to year basis. In Singapore, a relatively healthy SME is deemed as having a revenue of at least $300,000 per year.

2. Assets

Refers to anything that can be used as collateral to secure a loan. Types of assets that can be used as collateral in Singapore are usually property, equipment, or anything that can be easily liquidated.

3. Creditworthiness

Typically refers to the company director’s personal credit history and/or the past payment history of any debt that the company has raised before.

4. Cash flow

Possibly the most essential component when it comes to credit assessments. It typically looks at the debt ratio of a company, where revenue is taken against the total debt of the company. A reasonable debt ratio is 1.2 to 1.3 where revenue should always be more than debt.

For companies that are able to fulfill the above requirements, most institutional lenders are always willing to lend as they will have confidence in the ability of the borrowing entity to repay the business loan.

Invoice Financing And Other Debt Financing Options

If your company is unable to meet the four requirements above, but happen to have receivables from reputable companies, invoice financing may be a viable option. 

Invoice financing is the process of raising funds by selling off your accounts receivables to a third party financier. The cost of invoice factoring can be a little bit higher than the cost of traditional unsecured business loans, but can be a sensible choice if incoming revenues are able to repay the cost of the debt. 

Invoice financing terms usually last from 30 – 120 days. Credit assessments for invoice factoring typically look at 2 things: 

  • the reputation and credibility of the debtor
  • the credit worthiness of the borrower

Often times, new business owners do not know how or where to go to raise capital to grow their business.  However, if properly explored, there are a few good options out there. 

An option in Singapore could be the SME micro loan, which is quite easy to qualify for. It is limited to a maximum of loan amount  of $100,000. It may not be a lot of funds for a big company. but can certainly be very useful for a new startup business. There are also a few private financiers who are willing to lend on a short term basis, ranging from 6 – 12 months, at rates that are significantly higher than the traditional banks.

If all else fails, business owners can also look into taking up personal loans for their business. It can be a good option for the business owner who has a healthy personal credit history.  Interest rates may be a little bit higher than the average business bank loan , but repayment terms can be more flexible. Personal loan amounts can also be higher than a business loan if the business owner has a strong credit history.

Debt Financing vs Equity Financing

In conclusion, there could be many different combinations that a company could take to raise capital. Considering all the advantages and disadvantages of the available financing options is important. Therefore, do not rush into the decision but take time to determine which option or combination is the best for business.

Our Final Thoughts

Despite the apparent benefits of debt financing over equity financing, the final decision is yours to make. You are in the greatest position to analyze the risk vs return ratio and determine whether debt financing will yield a positive ROI in the long business.

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