Debt vs. Equity Financing

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There are two methods of business financing. The first is debt financing wherein money is borrowed from external sources such as banks [About, Inc.], finance companies, private corporations, credit card companies or credit unions [Allbusiness.com, Inc.]. Repayment is governed by the terms and conditions of an agreement, and it normally requires paying a monthly sum (part of total principal and part of total interest) over a specific time frame [About, Inc.]. The second method is equity financing wherein a part of the business ownership is traded for money [About, Inc.]. It involves taking on investors and being accountable to them. In case of small businesses, equity is usually raised from relatives, friends and customers as these players are interested in the wellbeing and success of the business. In case of large businesses like American Superconductor Corporation (AMSC), equity finance will come from venture capitalists (individuals, corporations and financial institutions) as these players are professional investors who are not averse to investment in risky new businesses [Allbusiness.com, Inc.].

If AMSC forgoes debt financing and takes on equity financing, it will enjoy five advantages, but will have to struggle against six disadvantages as well.

The first advantage is that equity can be retained permanently [Dynamic Equity Ltd.]. There is no obligation for AMSC to payback equity investment at any specific time, not even if it goes bankrupt. In this connection, AMSC will avoid the disadvantage posed by debt financing which involves prompt repayment of borrowed loans periodically; finance obtained in the form of loans cannot be retained permanently but has to be paid back in periodical instalments [About, Inc.].

The second advantage AMSC will enjoy is the strengthening of its cash flow. This is because cash that would otherwise be earmarked for debt repayment will be now freely available [About, Inc.]. Equity investors are rewarded by dividends, but only out of retained earnings [Dynamic Equity Ltd.]. AMSC will no longer be burdened by debt financings disadvantage of heavy debt repayment whereby its cash profits could be totally consumed in the process with the result that even if AMSC generates profit, there is no tangible form (cash) to show for it [About, Inc.].

The third advantage is that AMSC does not need to put forward any collateral in return for receiving equity contributions. As a result, AMSC will be able to safeguard all its business assets, some of which would have been put forward as collateral if AMSC continued with debt financing because collateral constitutes an important part of loan agreements that entitle the finance lender to legally appropriate those business assets in the event of default in repayment as per agreed terms [About, Inc.].

The fourth advantage is that the image of AMSC will enjoy a great boost because a business that possesses enough equity enjoys a good credit rating in the eyes of investors, lenders and tax authorities. AMSC will no longer be hindered by having to put its business reputation at risk due to debt financings feature of presenting large debts in the business entitys balance sheet, which results in weakening its credit standing and its competence to raise money in time to come [About, Inc.].

The last advantage of equity financing to AMSC is that the new equity investors will be genuinely interested in the wellbeing, progress and future prospects. They will expect returns on their investment only in the long run (usually between 3 to 7 years) [Allbusiness.com, Inc.]. The aggressive nature of equity investors will willingly accommodate downside risks as they take responsibility for the upside risks too. AMSC will no longer have to deal with debt financings conservative money lenders who know they cannot share any upside or profits and therefore seek to remove any possibility of loss or downside risks [Dynamic Equity Ltd.], not caring about the wellbeing or future prospects of AMSC, but being solely interested in getting back their investment in the short term in the form of regular paybacks.

The first disadvantage of equity financing AMSC will encounter is that its ownership will be compromised. The new equity investors will be entitled to a share in the business. AMSC will no longer retain full ownership that was the case with debt financing, where there was no question of giving up a share in business ownership to money lenders [About, Inc.].

The second disadvantage to AMSC will be the risk of interference in business operations and management from equity investors who could have different notions about how the business should be run. Personality conflicts could also add to the problem. In this regard, AMSC will lose the advantage of having no interference whatsoever from money lenders that it enjoyed when opting for debt financing [About, Inc.].

The third disadvantage to AMSC will be that its equity investors will be burdened by taxes, as the financing fees paid by AMSC (dividends) are taxable. This was not the case when AMSC opted for debt financing where the financing fee (loan interest) is allowed by tax authorities as a legitimate expense that is not subject to tax [About, Inc.].

The fourth disadvantage to AMSC will be that the equity investors will share the company profits indefinitely [Allbusiness.com, Inc.]. AMSC will no longer enjoy debt financings feature where leverage of company profits is facilitated, enabling it to utilise external finance to purchase its assets and retain its profits [About, Inc.].

The fifth disadvantage is that equity financing will be more expensive to AMSC as compared to debt financing, because the former involves giving up full business ownership and profit retention rights as compared to the latter scenario, where it had to repay only the loan amount and interest, without compromising business ownership or profit retention [Allbusiness.com, Inc.]

The last disadvantage to AMSC will be the lengthy time period involved. Getting equity finance is a time consuming process, as professional investors tend to scrutinise hundreds of investment possibilities each year before finally investing in very few of them [Allbusiness.com, Inc.]. AMSC will find that obtaining finance by this method is not as quick as debt financing.

In conclusion, it must be pointed out that it is a normal, accepted practice for investments into a business to involve both equity as well as debt financing a harmonious mixture necessitated because hundred percent debt financing involves a tremendous cash drain that will hinder optimal growth, while hundred percent equity financing sends a message that the future business prospects are every bleak and the business is not expected to generate enough profits to benefit from profit leverage [Dynamic Equity Ltd.]. However, as AMSC specialises in energy technology products, solutions and services especially in the field of wind energy, it enjoys the unique advantage of extraordinarily bright future prospects. According to the Global Wind Energy Council, the total installed base of wind power energy globally was 72,184 megawatts in 2006 and is expected to nearly doubt to 134,800 megawatts by 2010 [Superconductor Week], that is 3 years from now. As equity investors do not anticipate short-term but only long-term (3 to 7 years) investment returns [Allbusiness.com, Inc.], and therefore will be heartened by the tremendous future prospects of AMSC, it does appear that AMSC will be taking the right step by opting to forego debt financing and take on equity financing.

References

American Superconductors Power Electronic Systems Division Books $ 4.6 Million in New D-VAR [R] Orders for Wind Farms. Superconductor Week.
Debt vs. Equity? Dynamic Equity Ltd. 2007.
Funding your Business with Loans vs. Equity Capital. Allbusiness.com, Inc. 2007.
Minassian, Mark. Debt vs. Equity Financing. About, Inc. 2007.

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Debt vs. Equity Financing

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