Debt vs Equity: How Companies Raise Money

The two main ways companies fund themselves, the trade-offs between borrowing and selling ownership, and how leverage magnifies gains and losses.

Companies need money to start, grow and invest. They can raise it in two main ways: by borrowing, called debt financing, or by selling a share of ownership, called equity financing. Most companies use a mix of both.

Debt

With debt, a company borrows from banks or sells bonds to investors, promising to repay the amount with interest. Lenders do not own any part of the company and do not share in its profits beyond the agreed interest.

Debt has advantages. The original owners keep full control and all the extra profit if the company does well. In many countries, interest payments are tax-deductible, making debt cheaper. But debt must be repaid whatever happens. If profits fall, fixed interest payments can push a company into trouble.

Equity

With equity, a company sells shares to investors, who become part-owners. They share in profits through dividends and a rising share price, but they are not guaranteed anything. If the company does badly, shareholders lose.

Equity has no required repayments, so it is safer for the company. But it dilutes the original owners’ control and their share of future profits.

Leverage

Using debt to fund a business is called leverage. It magnifies both gains and losses for the owners.

The same business, two funding choices

Two investors each start identical businesses costing 1 million dollars. One uses only her own money. The other puts in 200,000 dollars and borrows 800,000 dollars at 5 percent interest. If the business earns 150,000 dollars a year, the first earns a 15 percent return. The second pays 40,000 dollars of interest, keeps 110,000 dollars, and earns 55 percent on her 200,000 dollars. But if the business earns only 30,000 dollars, the first still earns 3 percent, while the second loses 10,000 dollars after interest.

Finding the balance

Companies weigh these trade-offs to find a sensible mix, aiming for a low cost of capital, the overall return they must offer lenders and shareholders. Stable businesses with predictable cash flows, like utilities, often carry more debt. Young or risky companies, like tech start-ups, rely mostly on equity because they cannot safely promise fixed payments.

Thinking debt is always bad for a company

Debt is risky if overused, but moderate borrowing can make sense for businesses with steady profits. It is cheaper than equity in many cases and lets owners keep control. The danger lies in borrowing more than a company's cash flows can reliably support.

Key takeaways

Companies raise money through debt, which must be repaid, or equity, which sells ownership.
Debt keeps control with owners and is often tax-deductible, but adds fixed obligations.
Equity has no required repayments but dilutes ownership.
Leverage magnifies both gains and losses for owners.