A company generally consists of assets (Left Hand Side – LHS), and these assets have to be acquired with funding. The sources of funding are generally debt and equity (Right Hand Side – RHS).
Debt, simplistically, refers to money that is borrowed and that needs to be repaid, often with interest. On the other hand, equity refers to ownership in the business, and this does not need to be repaid.
In the example of a company wanting to acquire assets, it can either borrow money by issuing debt, or raise money by selling an equity stake in itself to another investor. The borrowed money would have to be returned some time in the future, while the money raised from issuing equity does not have to be.
Key differences between debt and equity
· Maturity – debt instruments generally have a maturity date (3/5/10/20yr), by which date the company has to repay the amount borrowed to the lender
· Control – borrowing via debt instruments is not exchanging an ownership stake in the company for money. But issuing fresh equity to new investors dilutes existing shareholders and weakens their control of the company. Many important decisions in the company, such as the appointment of directors and passing ordinary resolutions require the support of shareholders, but not creditors.
· Risk – debt instruments are generally considered less risky than equity because creditors know that the company is obligated to repay the amount borrowed on the maturity date. Because creditors are entitled to repayment, they will receive their money before equity holders receive any dividends. This is known as priority. The rule of thumb is that debt has priority over equity to receive cashflows from the company. Because creditors are first in line, they are more likely to receive their money than equity holders.
As financial instruments become more complicated, instruments that blur the line between debt and equity have emerged. For example, traditional debt instruments can be divided into loans and bonds. Whereas for equity, traditionally there are preference shares and ordinary shares, now there are hybrid-like instruments such as perpetual bonds, convertible debt, mezzanine debt etc.
Considerations that go into choosing either debt or equity
· Cost – The cost of debt is the interest that is payable on the amount borrowed, whereas the cost of equity is the dividend that investors demand for purchasing a stake in the company. Equity is generally considered more expensive than debt because equity is more risky and so requires greater compensation for the risk.
· Regulation – Regulation of issuing debt is less stringent than equity.
· Speed of execution – for companies with existing facilities with banks or financial trading venues, it could be faster to raise money via debt because regulation issuing debt is generally less stringent than regulation on issuing equity.
· Flexibility – a company issuing debt will find that it is subject to more restrictions on what it can and cannot do because debt instruments generally contain restrictive clauses to protect the position of creditors (remember, creditors are not able to participate directly in the management of the company). Besides, the company needs to repay the borrowed sum and interest on the borrowed sum regularly. In contrast, raising funds by issuing equity generally affords the company more flexibility as it can choose whether or not to pay dividends, depending on its financial position.
Debt and equity are not only required for companies to acquire assets. Companies may also take on debt if they face short term liquidity needs; such funds are for operational purposes. Separately, companies wishing to acquire another company will also need funds to fund the acquisition, often with a mix of the company’s own money, issuing debt and fresh equity.
Current market trend
“Companies raised a record $12.1tn in 2021 by selling stock, issuing debt and inking new loans” – FT
When interest rates rise, will this change?
Written by an SEO Law Alumni (Anonymous).