Introduction to Business Debt Financing
A business can finance its operations either through equity or debt. Equity is cash paid into the business by investors; the business owner is usually one of these investors; investors receive a share of the company, in effect a percentage of it proportional to total investment paid in. The share or stock may appreciate in value in proportion to the increase in the business’s net worth—or it may evaporate to nothing at all if the business fails. Investors put cash into a company in the hope of stock appreciation and the yield of dividends which the business may (but need not) pay to the investor; dividends are a portion of the net profits of the business; if the business does not realize a profit, it cannot pay a dividend. The investor can get his or her investment back only by selling the share to someone else. In a privately held company, investors have less “liquidity” because the shares are not traded on the open market and a purchaser may be difficult to find. This is one reason why successful and rapidly growing small businesses are under pressure by stockholders to “go public”—and thus to create an easy way for investors to cash out.
Debt financing, by contrast, is cash borrowed from a lender at a fixed rate of interest and with a predetermined maturity date. The principal must be paid back in full by the maturity date, but periodic repayments of principal may be part of the loan arrangement. Debt may take the form of a loan or the sale of bonds; the form itself does not change the principle of the transaction: the lender retains a right to the money lent and may demand it back under conditions specified in the borrowing arrangement.
Lending to a company is thus at least in theory more safe, but the amount the lender can realize in return is fixed to the principal and to the interest charged. Investment is more risky, but if the company is very successful, the upward potential for the investor may be very attractive; the downside is total loss of the investment.
