According to the finance theory - there are two basic ways to finance the activity of a business - equity and foreign capital.

Equity is an investment by owners who expect to receive an inevitable return for their investment. On the other hand, foreign capital is a loan from banks or bondholders who wish to receive the principal and the interest they promised.

So which of the alternatives is better - equity or foreign capital?

The first question is, does the company even have a choice? Young startups don't have many options. They have no real estate. They have no patents and no products. They don't have sales either. Therefore, the chance that they will be able to get a loan from someone is relatively low.

Therefore, the only financing option for businesses, or almost the only one, is equity.

But if the firm is given a choice - equity versus debt - how can it decide?

One possibility is to examine the alternatives. For example - if the firm can get a loan of 100,000 US dollars, at a rate of 5% per year, or - 100,000 dollars for 10% of the shares - what should the shareholders choose - equity or debt?

The answer depends on the values ​​of the company in a year. In a year, the company has to pay the debt holders $105,000. With the company's value in a year being $200,000, they will be left with $95,000 - in the debt alternative and only NIS 180,000 in the equity alternative. In this case, the equity alternative is preferable.

If, on the other hand, the company's value in a year is 525,000 USD - the current shareholders will be indifferent. In both alternatives, they will have 420,000 dollars, and if the company's value in a year is expected to be 1,000,000 1,000,000 dollars, because in the debt alternative - the shareholders will be left with 895,000 dollars, while in the equity alternative - 800,000 dollars.

Infographic: Equity Vs. Debt

Therefore, the conclusion is that when you have to decide on equity or debt - you need to understand what the company's value is expected to be in a year.

By the way - if you need a business valuation report, you can build a professional report in 30 minutes using our intuitive ai based business valuation software or our business valuation calculator, or you can contact us for free advice.