Equity and debt are the two primary types of capital you can use to fund your small business. When you raise equity capital, also called share capital, you give an investor shares of stock in exchange for cash. Stock represents an ownership position in your business. Knowing the share capital advantages and disadvantages can help you decide how much equity financing to use.
Advantage: No Repayment Requirement
When you use equity capital, you have no obligation to make interest payments or to repay equity investors’ initial investment. Debt capital, on the other hand, requires periodic interest payments and repayment of the borrowed principal. Although you might distribute some of your profits as dividends to equity holders, you can skip these payments if necessary. This advantage helps your small business keep more of its profits and allows more spending flexibility.
Advantage: Lower Risk
In general, a business that uses more equity than debt has a lower risk of bankruptcy. If a business suffers a setback and fails to make its interest payments, its creditors can force it into bankruptcy. Equity investors have no such rights. They must wait out any potential downturns to be able to benefit when a business prospers. For example, assume you finance your small business with all equity and have a bad year. Investors might be disappointed, but their only option is to hope for improvement.
Advantage: Bringing in Equity Partners
While the money is a definite advantage of new equity, the partners that you'll work with also have a vested interest in seeing your business succeed. If these partners have a good deal of expertise, connections and influence, this could make all the difference between a struggling or thriving business. Additionally, having good equity partners can make increase the odds of securing more attractive debt if needed in the future.
Disadvantage: Ownership Dilution
Various share capital pros and cons exist, but one of the worst negatives as an owner is the loss of control over the company. The advantages of owners capital investments typically include a certain amount of control over the enterprise through the ownership of a large percentage of the company's shares of stock.
With every share of stock you sell to investors, you dilute, or reduce, your ownership stake in your small business. Because equity investors typically have the right to vote on important company decisions, you can potentially lose control of your business if you sell too much stock.
For example, assume you sell a majority of your company’s outstanding stock to raise money, and investors disapprove of the company’s progress. In this case, because of your choices and your reduced ownership percentage, they might have the power to vote you out of a leadership position and bring in new management.
Disadvantage: Higher Cost
Although equity does not require interest payments, it typically has a greater overall cost than debt capital. Stockholders shoulder more risk from their perspective compared to creditors because they are last in line to get paid if the company goes bankrupt. Consequently, equity investors demand a higher rate of return on their investment. You typically must give up more stock for a lower price when you raise equity to compensate investors for this risk.
Disadvantage: Time and Effort
It takes a good deal of time and effort to get a loan, from getting through the loan application to getting through the underwriting process. However, the process to secure equity funding can be even more time-consuming and arduous. It typically takes the right connections and a powerful pitch deck to get the equity you need.
FAQs
Although equity does not require interest payments, it typically has a greater overall cost than debt capital. Stockholders shoulder more risk from their perspective compared to creditors because they are last in line to get paid if the company goes bankrupt.
What are the advantages and disadvantages of equity capital? ›
Pros & Cons of Equity Financing
- Pro: You Don't Have to Pay Back the Money. ...
- Con: You're Giving up Part of Your Company. ...
- Pro: You're Not Adding Any Financial Burden to the Business. ...
- Con: You Going to Lose Some of Your Profits. ...
- Pro: You Might Be Able to Expand Your Network. ...
- Con: Your Tax Shields Are Down.
Dilution of ownership and operational control
The main disadvantage to equity financing is that company owners must give up a portion of their ownership and dilute their control.
What are the advantages and disadvantages of equity finance? ›
The advantages of equity financing include not having to make regular repayments and sharing the risk with investors. However, it also means giving up a part of ownership and decision-making control.
What are the advantages of equity share capital? ›
Advantages of equity share capital
Equity share capital represents permanent capital for the company since it does not have a fixed maturity date. Unlike debt, which requires periodic interest payments and eventual repayment, equity capital is a perpetual source of funds.
Why is equity capital better? ›
Less burden.
With equity financing, there is no loan to repay. The business doesn't have to make a monthly loan payment which can be particularly important if the business doesn't initially generate a profit. This in turn, gives you the freedom to channel more money into your growing business.
What are the positive and negative effects of equity? ›
Ans (i) Equity Two positive effects of equity are given below: [a] It ensures loyalty among the workers. [b] It emerges cordial relation between workers and managers. Two negative effects of equity, if violated are given below: [a] Dissatisfaction among employees leading to greater employee turnover.
What is the risk of equity capital? ›
The risks of investing in equity include share price falls, receiving no dividends or receiving dividends lower in value than expected. They also include the risk that a company restructure may make it less profitable. Alternatively a company may fail.
What are the three limitations of equity share capital? ›
Limitations of Equity Shares
Investors who prefer steady income may not prefer equity shares. The cost of equity shares is higher than the cost of raising funds through other sources. The issue of additional equity shares dilutes the voting power and earnings of existing equity shareholders.
Why equity capital is considered riskier than debt capital? ›
Answer and Explanation: Equity Capital remains in the business until it is dissolved. Equity stockholders are owners of a firm, unlike debt holders. A business is assumed to continue till infinity and the capital of owners stays invested until it is dissolved.
Capital is a broad term for anything that gives its owner value or advantage, like a factory and its equipment, intellectual property like patents, or a company's or person's financial assets. Even though money itself can be called capital, the word is usually used to describe money used to make things or invest.
Why is equity financing so expensive? ›
Because equity capital typically comes from funds invested by shareholders, the cost of equity capital is slightly more complex. Equity funds don't require a business to take out debt which means it doesn't need to be repaid.
What is equity capital and its advantages and disadvantages? ›
When you use equity capital, you have no obligation to make interest payments or to repay equity investors' initial investment. Debt capital, on the other hand, requires periodic interest payments and repayment of the borrowed principal.
What is an example of equity capital? ›
Stock is an ownership interest in a corporation. For example, Lisa may form a corporation and issue 5,000 shares of stock and sell some of the shares to her friend for $100 per share. If she sells all 5,000 shares, she will have raised $500,000 in equity capital.
What is the difference between equity and equity capital? ›
Equity helps determine whether a company is financially stable long term, while capital determines whether a company can pay for the short-term production of products and services. Capital is a subcategory of equity, which includes other assets such as treasury shares and property.
What are the advantages of raising equity capital? ›
There are many advantages of equity financing for companies seeking to raise capital, including: There are no repayment obligations. There is no additional financial burden. The company may gain access to savvy investors with expertise and connections.
What are the advantages and disadvantages of share capital? ›
Overall, using share capital instead of taking out a business loan can offer a company more financial flexibility. Increasing a company's share capital can lead to the shares of existing shareholders becoming diluted. This can affect both dividend pay-outs and voting rights.
What is equity method advantages and disadvantages? ›
Shared risk: The equity method allows for shared risk between the investor and the investee. This means that if the investee performs well, the investor is likely to benefit from the profits. On the other hand, if the investee performs poorly, the investor is likely to suffer losses.
What are the advantages and disadvantages of equity market? ›
Advantages and Disadvantages of Equity Shares
- Potential for High Returns.
- Dividend Income.
- Liquidity.
- Diversification.
- Inflation Hedge.
- Market Volatility</4>
- No Guaranteed Returns.
- Dividends are Not Guaranteed.
