Is it Cheaper to Raise Equity or Debt?

Debt is almost always cheaper than equity when it comes to financing a business. Learn why debt is cheaper and how to decide which option is best for your business.

Is it Cheaper to Raise Equity or Debt?

Since debt is almost always cheaper than equity, debt is almost always the answer. Debt is cheaper than stocks because the interest paid on debt is tax-deductible and the expected returns of lenders are lower than those of stock investors (shareholders). Both the risk and the potential return on debt are lower. When financing a company, the cost is the measurable expense of raising capital.

In the case of debt, this is the interest expense that a company pays on its debt. In the case of share capital, the cost of capital refers to the claim on the profits offered to shareholders for their participation in the ownership of the company. Debt can be much cheaper than capital if the company grows to a point where it sells for a substantial sum. Then, instead of having to pay your shareholders their percentage share, you keep full ownership and simply cancel the loan.

The Institute of Corporate Finance states that equity financing is generally more expensive than debt financing. This is because equities carry greater risk for investors. Individuals and institutions that buy shares in a company are not guaranteed capital gains or dividend payments, have limited rights to assets in the event of a company's bankruptcy, and are more exposed to volatility than in the debt market. To compensate for these risks, investors expect higher rates and more returns in return (a concept called equity risk premium).

Equity financing can be less risky than debt financing because you don't have a loan to repay or guarantees at stake. Debt also requires periodic payments, which can affect a company's cash flow and its ability to grow. Equity funding can range from a few thousand dollars raised by an entrepreneur from a private investor to an initial public offering (IPO) on a stock exchange worth billions. Participation refers to raising capital through the sale of shares in a company, while debt financing is the generation of capital through the loan of funds that are then returned with interest over a period of time.

When deciding between raising debt funds and raising capital funds, it will depend entirely on your business and where you are in your business journey. The cost of each option should be carefully considered before making a decision. Equity financing may be more expensive but it also carries less risk than debt financing. Ultimately, it's up to you to decide which option is best for your business.