When a business is expanding, it has numerous options available to them that it can use for purposes of expansion.
This decision-making is largely impacted by the preference of the company when it comes to raising finance through two main streams of financing: debt and equity financing.
Given the fact that both these types of financing have their advantages as well as disadvantages, it can be seen that there is no concrete financing type that can be defined as the best for the company.
In most cases, it can be seen that companies often opt for a mix of debt and equity financing in order to balance their leverage position that is meant to yield a favorable outcome considering the cost of capital of the company.
How to change from debt financing to equity financing
Debt financing can be defined as a financing tool for the company which involves companies raising finance by signing on long-term loans in exchange for a certain finance charge, which is interest.
It does not alter the ownership structure of the company. On the other hand, it can be seen that equity financing involves the company raising finance by selling a certain percentage of ownership in the company.
In the case where organizations seem it necessary to shift from debt financing to equity financing. There are certain tips and tricks that might come in handy.
- Firstly, it can be seen that it is imperative to consider the costs associated with the shift. This is an important part of the process because of the reason that equity financing tends to be more expensive as compared to debt financing. In the case where the company has not had an initial public offering, it is quite expensive to get an IPO. This requires underwriting and ensuring that all the legal documents are taken care of. This trade-off needs to be accounted for so that planning can be carried out in accordance with that.
- In the same manner, it is also important to ensure that the timeline associated with equity financing is accounted for. Equity financing is not always a quick alternative. Therefore, it takes considerable time. If the company needs to arrange funds for expansion or any other major expense, it is preferable to act in advance, so that timelines can properly be managed.
- The overall change in ownership of the existing shareholders should also be accounted for when shifting from debt to equity financing. This is an integral part of the overall process because it tends to be a demotivating factor for the existing shareholders. When the company is issuing more shares, they are getting more owners within the existing lot. Therefore, the ownership of the current shareholders is diluted. This needs to be prevented by incentivizing the existing shareholders through a rights issue, or some other means that can prevent the issue of dilution at large.
- There should be clarity between the finance that needs to be raised when selling off shares of the company. This affects the leveraging status of the company, and it might also have repercussions on the optimal structure of the company. Debt financing tends to be cheaper and offers tax benefits for the company. Therefore, a total shift towards equity financing is discouraged because it adversely affects the financial standing of the company in this regard. The calculations should be made well in advance.
- When shifting from debt financing to equity financing, it is also important to consider the type and category of shares that are going to be sold in return for the investment. For purposes of simplicity, it is often preferable to have lesser shareholders with voting rights, in order to protect the interests of founding shareholders, at large.
Therefore, there is no doubt about the fact that shifting from debt financing to equity financing tends to be a major shift in the company dynamics.
This is something that needs to be duly addressed on multiple grounds so that transition is smooth, and the financial impact on the company is well under control in numerous aspects.
This planning and execution is something that needs to be done at both, a corporate level, as well as an executive level so that proper decision-making is carried out and the correct decision is taken with a proper way forward.
When selling shares, the company needs to have clarity regarding its offering, in order to streamline the process.