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Capital structure is a term that describes the proportion of a company's capital, or operating money, that is obtained through debt versus the proportion obtained through equity. Debt includes loans and other types of credit that must be repaid in the future, usually with interest. Equity involves selling a partial interest in the company to investors, usually in the form of stock. In contrast to debt financing, equity financing does not involve a direct obligation to repay the funds. Instead, equity investors become part-owners and partners in the business, and thus earn a return on their investment as well as exercising some degree of control over how the business is run.
Since capital is expensive for small businesses, it is particularly important for small business owners to determine a target capital structure for their firms. Capital structure decisions are complex ones that involve weighing a variety of factors. In general, companies that tend to have stable sales levels, assets that make good collateral for loans, and a high growth rate can use debt more heavily than other companies. On the other hand, companies that have conservative management, high profitability, or poor credit ratings may wish to rely on equity capital instead.
Both debt and equity financing offer small businesses a number of advantages and disadvantages. The key for small business owners is to evaluate their company's particular situation and determine its optimal capital structure. An optimal capital structure is one that strikes a balance between risk and return and maximizes the price of the stock while simultaneously minimizing the cost of capital.
The primary advantage of debt financing is that it allows the founders to retain ownership and control of the company. In contrast to equity financing, debt financing allows an entrepreneur to make key strategic decisions and also to keep and reinvest more company profits. Another advantage of debt financing is that it provides small business owners with a greater degree of financial freedom than equity financing. Debt obligations are limited to the loan repayment period, after which the lender has no further claim on the business, whereas an equity investor's claim does not end until his or her stock is sold. Debt financing is also easy to administer, as it generally lacks the complex reporting requirements that accompany some forms of equity financing. Finally, debt financing tends to be less expensive for small businesses over the long term than equity financing. Over the short term, however, debt financing is far more expensive.
The main disadvantage of debt financing is that it requires a small business to make regular monthly payments of principal and interest. Very young companies often experience shortages in cash flow that may make such regular payments difficult, and most lenders provide severe penalties for late or missed payments. Another disadvantage associated with debt financing is that its availability is often limited to established businesses. Since lenders primarily seek security for their funds, it can be difficult for unproven businesses to obtain loans without a personal guarantee from one of the principals in the business.
The main advantage of equity financing for small businesses, which are likely to struggle with cash flow initially, is that there is no obligation to repay the money. Equity financing is also easier to acquire than debt financing for early-stage or start-up businesses. Equity investors seek growth opportunities, so they are often willing to take a chance on a good idea. But debt financiers seek security, so they usually require the business to have some sort of track record before they will consider making a loan. Another advantage of equity financing is that investors often prove to be good sources of advice and contacts for small business owners.
The main disadvantage of equity financing is that the founders must give up some control of the business. If investors have different ideas about the company's strategic direction or day-today operations, they can pose problems for the entrepreneur. In addition, some sales of equity, such as initial public offerings, can be very complex and expensive to administer. Such equity financing may require complicated legal filings and a great deal of paperwork to comply with various regulations. For many small businesses, therefore, equity financing may necessitate enlisting the help of attorneys and accountants.
SEE ALSO Debt Financing; Equity Financing
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Hillstrom, Northern Lights
updated by Magee, ECDI