Every business must maintain a reasonable proportion between the amount of debt that it has compared to the amount of equity. While businesses use each one as a source of funds, there are advantages and disadvantages to both. Financial decisions must be weighed carefully to determine which method is best for the company.
When lenders make loans, they set up the terms of repayment of principal and interest on a specific schedule. The borrowers must meet this repayment schedule whether they have profits or not. Not meeting the repayment requirements will result in a default of the loan. Investors who contribute equity capital and receive shares in the business do not have any assurance that they are going to receive back any of their investment. They hope the value of their investment will increase and that they will receive dividends. However, the company is under no obligation to pay dividends. The repayment of loans takes precedence over the distribution of any dividends.
Unless the company is financially strong, lenders usually put restrictions on their loans. They may require that their loans be secured by either current or fixed assets. The lender could also add covenants that require the company to maintain certain minimum amount of working capital or restrict the ability of the business to borrow more money. Equity shareholders do not have a direct claim on any of the company's assets. They would only receive a return if the company were liquidated and there were funds left after payment to all of the creditors. If the company is privately held, shareholders may not have the ability to sell their shares because there are no buyers nor any actively traded market. While equity does not have the same restrictions as a loan, taking on additional shareholders does mean that the owner has more partners who have a right to voice their opinions about how to manage the business. An owner may or may not agree with them, and this could cause conflicts in the future.
Equity shareholders expect to receive a high return on their investment because they are taking a high risk. They have no assurance that the value of their stock will increase and no guarantee of receiving dividends. According to "Entrepreneur" magazine, equity investors expect to receive a 35 percent to 45 percent after-tax return on their investment. The interest on loans is less than the shareholders' expected return on investment. However, lenders have more security for their loans and have a specific schedule to receive their money back.
When a business is starting up, equity investment may be the only source of funds. Lenders usually require a history of consistent profit performance before they will make a loan. They want to have a reasonable expectation that the company will have the necessary cash flow to repay their loans. Lenders also want to see a substantial amount of equity investment in the business. They want to know that the owner has committed his personal funds to the business and that he has something to lose if the company goes bankrupt.