When thinking about your best investment options, bank products come first. Senior debt and junior debt or otherwise called second lien loans or subordinate debt are two options you may consider before you start thinking about equity financing. Here are some pros and cons of bank products and equity financing.
Senior debt is the most common and the lowest cost funding, but when it comes to repayment, the banks sit at the top of the liquidation pecking order. In other words, you have to pay every cent before anyone gets anything.
Junior debt is considerably more expensive than senior debt but sometimes you are willing to face the cost for an extra slice of money that the bank is willing to give in the form of junior debt. One advantage of junior debt is that it is an unsecured debt- no collateral is required. However, as a trade-off, you have to pay higher interest rate. Such debt may be appealing to entrepreneurs who are looking for quick liquidity. The debt may also be converted to equity.
In the case of both type of debt financing, you maintain control over your business provided you to keep your obligations.
You may also be attracted by tax deduction. In most of the cases, the interest payments on a business loan are classified as business expenses and subsequently can be deducted from your business’s income at tax time.
With equity financing instead of spending cash on loan payment, you can use the flow to grow your business. This time you would not be required to return the original investment in case of business failure.
With debt financing you’ll still have to make repayments even if your business fails. The interest rates may vary with macroeconomic conditions, your business credit rating and personal credit history. Finally, most likely you have to have collateral in case of default on your payment. In this case, the lender can foreclose on the property. The lender can also sell the property or take over the ownership of the property.
Equity is the total opposite of debt financing. It bears the highest risk with zero security. If you are thinking about short-term investment, equity financing is not the right solution.
There is also a possibility that the shareholder may want to merge with another company, sell the company to a larger firm or conclude a public stock offering. After all, when calculating your profits, you may find that you are paying a larger percentage of your profits to investors than you would pay to a bank.
Which to choose?
When deciding on investment type, Alternative Capital Marketplace recommends to consider control, cost, risk, priority and cash payments.
The less control the funding providers have to intervene in your business, the better. In the case of bank products, the bank normally does not intervene in your business provided you keep to your obligations. With equity financing you depend on shareholders.
The lower the cost of funding, the better. With equity financing you basically pay no interest rate on your cash whereas the interest rate may be high with junior debt financing especially in volatile trading conditions.
The higher the appetite to fund complex/high risk opportunities, the better. It’s always good to find high risk business loans but as Wall Street Funding puts it, “there is more trouble with this form of lending than most people perceive.”
The lower the pecking order of repayment, the better. Bank products, especially senior debt has the highest pecking order of repayment but you may also need to be aware where the bond sits in the pecking order of repayment in case the issuer goes into receivership.
Finally, the less burden you have on business cash flow, the better. Alternative Capital Marketplace argues that it is a “common pitfall to think of equity as being cheaper than debt, just because there are no interest payments. In fact equity is the most expensive form of funding. While a debt provider has a capped return (determined by the interest rate) an equity investor owns a piece of the company and shares in the company’s success, with no upper limit”.