Stock Market Basics > equity vs debt financing

Debt vs Equity Financing

Imagine for a moment that you are a small business owner. You have been running your widgets company quite successfully, employing a small staff and enjoying the profits rolling in. So why would you share these profits with literally thousands of people?

The answer is simple: in order to grow, a company needs to either go into debt, sell a part of the company in order to raise money. So you can either finance that growth by borrowing from the bank, or by issuing bonds. This is called debt financing. So while you own 100% of the company, you owe a lot of money.

On the other hand, you could sell stock in the company. No interest payments, no money to pay back. Only the promise that the shares will be worth more some day. Of course, now these new shareholders now can lay claim to the assets and profits of the company. This is called equity financing.

An IPO is an Initial Public Offering is the first sale of a companies stock that is issued from a private company.

From an investors point of view, there is a large difference between investing in debt versus investing in equity. By investing in a debt instrument such as a bond, you are guaranteed the principal of the bond, plus any interest that is owing. However, for equity investors, you become an owner. As such, you also take on the risk of the company not being a success. Just as a small business owner has no guarantee of success with each new venture, neither is a shareholder. If things dont turn out well, you get to claim the assets of the company, but only after the creditors have been satisfied, which is usually nothing. As a shareholder, if the company is successful, you stand to make a lot of money. On the flipside, you stand to lose a lot of money if the company is less than successful.

Risk Vs Reward
Its important to understand the risk that is inherent with investing in stocks. There are no guarantees or obligations. Some companies will pay out a dividend, while others will not. There is no obligation for a company to pay a dividend, or even increase a dividend. If there is no dividend paid out, then the only way for an investor to make money is through the increase in share price on the stock market. If the shares decrease, the shareholder value is lowered. If the company goes bankrupt, your investment is worthless.

Risk should always be balanced out with reward. By taking on more risk, you should be compensated with the potential for a greater return. This is why small caps have historically outperformed large caps and why the return on investment in stocks in general have more than doubled that of bonds or savings accounts. The stock market over the last 50 years has returned over 12% per year.

However, that return is not without its risk.