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Comparison of equity vs. debt as modes of raising capital

Broadly speaking, a business can raise money in two ways to finance its activities – equity and debt. Equity can be raised either from the public through stock exchanges in case of listed companies, or can be raised from private investors (such as private equity or venture capital funds, high networth individuals or HNIs, corporates or even sovereign wealth funds). The cheapest source of capital is to raise money from the public, as this money can be raised without onerous contractual conditions (unlike a VC or PE fund or even a strategic investor will impose) and there is no legal necessity to pay back such money to the investors or provide a profitable exit as is essential for a VC. Investors who buy stocks on a stock exchange only expect to get dividends if the company profits. Of course, dilution of ownership or control is also a cost of raising equity – but for large corporations there is hardly a significant change in ownership percentages if they raise equity from the public.

For others, the cost of losing control by giving out equity may be too much and hence they may prefer issuing debt. While debt is usually a cheaper source of capital than VC, PE or private investor money (in the sense that you don’t have to share profits if you make money and your outflow is limited to the interest payment), there is always a pressure on the company to pay interest regularly and repay the principal after a fixed amount of time. Failure to do so can result in recovery actions and bankruptcy of the company (for more details on what else you can do if your company fails to pay debt, see here for a discussion of how restructuring works).

In the earlier chapters, we explained how to raise equity finance. In this chapter, the nuances of debt finance and loan agreements are explained.

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