Businesses seeking funding through investors typically consider two options: debt financing and share financing. Debt financing involves borrowing money from investors by issuing corporate bonds. Share financing involves selling ownership rights in the company to investors by issuing stock. Investors are rewarded for financing companies through interest and dividend payments.
When a company borrows money to finance its business operations through the sale of corporate bonds, the company agrees to repay investors' loans within a given time and makes interest payments to its investors as an incentive. Some companies favor debt financing because loan interest payments are typically tax deductible and the company doesn’t dilute its ownership rights. Some investors favor investing in debt because it allows them to receive a fixed amount of income for a specified time period.
Share financing, commonly called equity financing, involves a company issuing shares of its stock to investors to raise money. The shares represent units of ownership within the company. Unlike debt investing, investors do not receive a fixed income amount. The company issuing the stock may decide to pay dividends to investors, but that is at the discretion of the company. Some businesses favor equity financing because they are not legally responsible to repay the money. Many investors buy equities because the price of a stock can appreciate substantially, offering an attractive return on their investment.
A company with a poor credit rating will need to offer a high interest rate to investors to obtain debt financing. In contrast, equity investors determine the value of a company by its historical and present financial performances. Equity financing is a long-term venture, and the company does not control how long investors hold ownership rights within the business. Some investors hold on to a company’s shares for many years. Debt financing terms can vary in length. Some companies choose to issue bonds for five years, while others issue 30-year bonds. Once the money is repaid, the relationship between the company and investor is over.
Compared to debt financing, equity financing is considered less risky. A new company may find it challenging to repay its debt obligations, especially during economic downturns and rising interest rates. Although less risky, equity financing also comes with risks. Shareholders who gain majority control in a business can influence major operational decisions within the company.