The basic distinction is that
with debt financing a company will borrow money from a lender and will in return make a promise to return the initial borrowed sum + an agreed upon interest. With equity financing, the company gets money from an investor but never has to pay the investor back in return. Instead,
in exchange for the money the investor gets equity in the company, which is just another term for shares in the company/a percentage of the ownership of the company. Equity financing always takes place when a private company goes public, in that the company issues shares to the public through an IPO and in exchange gets capital which can be used for further growth. However, equity company can also be used by a private company in a private transaction, when existing shareholders agree to sell a part of their shares or issue new shares to a particular investor/group of investors.
To look in more detail at debt financing, the main two methods to obtain it are loans (normally taken from a bank) and bonds (which can be issued to any investors). The difference is that loans normally have to be repaid on a monthly period (the borrower pays a proportional part of the total borrowed sum + interest) while with bonds, the issuer (ie the company that borrowed the money) only has to make the interest payments on a regular basis - the initial borrowed sum (or "the principal") is paid all at once at the end of the agreed upon repayment period (the "maturity date"). While there are a number of other differences that are relevant in assessing the pros/cons of using loans or bonds, for the sake of comparison with equity financing I will look at only advantages and disadvantages that equally apply to both. It should be noted however that in PE generally and for buyouts in particular P
E firms normally use highly leveraged loans. Essentially, to minimize the amount of investor capital spent on any transaction (and thus to maximize the total number of profitable transactions a given fund can enter into), a PE firm will normally finance around 75-80% of the cost of a buyout by getting a loan from a bank and then offering as security the assets of the target company itself.
Now, to list some of the main
advantages of debt financing I can think of:
- Allows the company (and the controlling PE firm) to keep compete control of the target company. This is particularly important for the PE firm to be able to implement its growth/efficiency improvement plans and its desired exit strategy.
- Allows the PE firm to keep all the dividends and profits from selling the company later on.
- It is often makes for a simpler and more standard negotiation process both for the financing deal and for the actual buyout. For an industry like PE where deals tend to be very fast paced and where targets normally have a number of suitors, this is also a benefit that should not be understated.
- Interest payments are tax-deductible.
Whereas the main
advantages of equity financing are:
- It does not add any financial burdens on the target company. This means it should have more capital which can go towards investments in growth rather than repayment of debt. It also decreases risks of insolvency.
- It often means working with institutional investors or huge corporates with significant resources and expertise, which can make them invaluable partners for growing a business. A very successful example of such a relationship is that between Open AI and Microsoft.
