Debt Capital Vs Equity Capital

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  • 0:03 Raising Capital…
  • 0:49 Pros & Cons of Using Equity
  • 2:01 Raising Capital through Debt
  • 2:41 Pros & Cons of Using Debt
  • 3:45 Raising Capital &…
  • 4:11 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley
Sufficient capital is essential for starting, maintaining and growing a business. In this lesson, you'll learn how a corporation can raise capital through equity and debt. You'll also learn about the advantages and disadvantages of each approach.

Raising Capital through Equity

Meet Lisa. She's an executive chef at a famous New York restaurant. Her friends have convinced her to start a company that produces prepared frozen meals based upon some of her signature creations. Lisa's savings isn't sufficient to cover the startup costs of the new venture. So she needs to raise capital. Capital is simply a financial asset, such as money.

Lisa can raise capital through equity. Equity capital is capital that comes from the sale of stock to investors. Stock is an ownership interest in a corporation. For example, Lisa may form a corporation and issue 5,000 shares of stock and sell some of the shares to her friend for $100 per share. If she sells all 5,000 shares, she will have raised $500,000 in equity capital.

Pros & Cons of Using Equity

Let's assume Lisa decides to raise equity capital. She forms her new company as a corporation and authorizes the issue of the 5,000 shares of common stock that we discussed above. She convinces three of her closest friends to invest $100,000 each for 1,000 shares apiece. She contributes $200,000 of her personal savings to the corporation for the remaining 2,000 shares. Her company now has an infusion of $500,000. Moreover, Lisa's company is not in debt. If she needs to obtain additional financing, lenders will be more willing to lend to Lisa because of the solid financial footing established by the equity capital.

Lisa does have some new business concerns after raising the equity capital. Now, she has shareholders who will expect a return on their investments. In fact, Lisa put herself in a bit of a bind. She holds two-fifths of the shares to her company, and the other shareholders collectively hold three-fifths of the shares. This means that Lisa can lose control over the management of her company to the other shareholders because they control more votes than she does. Lisa could have avoided this problem by issuing preferred shares to her investors that guarantee dividends, but don't empower the shareholders to vote like shares of common stock do.

Raising Capital through Debt

Lisa may not want to deal with meddling investors telling her how to run her business. Instead of raising capital through equity, she may want to raise capital through debt. Debt capital is capital that has been raised through borrowing from a source outside the company.

Lisa can offer debentures to investors to raise money. A debenture is an unsecured debt obligation, such as a promissory note or a corporate bond, that a corporation offers to investors in exchange for a loan. Since debentures are not secured by any property, investors must rely upon the creditworthiness of the company to decide whether to loan money. Investors will receive interest as compensation for use of their money.

Pros & Cons of Using Debt

Now, let's assume Lisa decided to raise capital through offering debentures. Instead of taking on shareholders, Lisa's company becomes a debtor. Her company will be able to deduct the interest payments against its revenue as a necessary and ordinary business expense. And Lisa doesn't have to worry about shareholders demanding a better return or trying to take control of her company.

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