Equity Vs Debt Investment: Key Differences Explained

There are two fundamental ways to invest in a company: debt and equity investments. Debt investments are a form of loan, where investors lend money to a company in exchange for repayment with interest at a later date. On the other hand, equity investments involve buying shares of ownership in a company, which entitles shareholders to a share of the profits. This article will explore the key differences between these two investment types and help you understand which one may be more suitable for your needs.

Risk and return

Equity investments are considered riskier because they are more volatile and are not guaranteed to generate returns. They are also riskier because, in the case of bankruptcy, equity investors may lose their entire stake. Equity investors are also the last to be paid if a company is liquidated.

Debt investments are generally considered safer because they offer fixed returns and have a higher claim on assets during liquidation. However, there is still a level of risk involved, as there is no guarantee that borrowers will make their payments.

The level of risk an investor is willing to take will significantly impact the types of investments they choose. Those who are risk-averse may prefer low-risk investments like cash and government bonds, while others may be willing to take on more risk for the potential of higher returns.

For businesses, the decision to choose between debt and equity funding depends on a range of factors, including the value exchange between the business and the lender, the business's existing capital structure, and the stage of the business life cycle.

Debt financing requires no equity dilution, but the business must pay interest on top of the initial sum. Equity financing, on the other hand, requires sacrificing a stake in the business and future profits but does not require the payment of interest.

From a business perspective, debt financing can be more affordable than equity financing, as the business retains complete ownership of its future success and profits. However, debt financing must be repaid, and the business must be confident in its growth assumptions and have a clear plan for how it will use the funds.

Equity financing, on the other hand, may be more attractive to younger and less established businesses, as there is no pressure to meet firm repayment schedules, and the input of a professional investor can positively influence the business's growth. However, equity financing can be expensive, and established businesses may be reluctant to relinquish control to external parties.

Overall, investors and businesses need to carefully consider their risk tolerance, financial goals, and other factors when deciding between debt and equity investments.

Control and ownership

Equity financing involves selling shares of ownership in a company. This means that the investor becomes a partial owner of the company and gains certain rights, such as sharing in the profits of the company, either directly through dividend payments or indirectly by selling shares at a higher price than they bought them for. Equity investors may also seek additional protections, such as being appointed as a director to control day-to-day operations or being issued different share classes to maintain some control over the business.

On the other hand, debt financing is a form of borrowing that requires no equity dilution. The business owner retains complete control and ownership of the business, and there is no obligation to involve the lender in day-to-day operations. However, debt financing often comes with additional terms and conditions, such as security agreements and covenants, which are put in place to improve the position of the debt investor.

Equity financing may result in dilution of ownership and a loss of control for the original owner, as they will need to consider the interests of the new shareholders. In contrast, debt financing allows business owners to maintain full control and ownership of their business, but comes with the obligation to repay the loan, often with interest, and may include additional terms and conditions.

The decision between debt and equity financing depends on the business owner's priorities and the stage of growth of the business. If maintaining control and ownership is a key priority, debt financing may be preferable, provided the business can manage the repayment schedule. Equity financing may be more suitable for earlier-stage businesses or those seeking input from professional investors, despite resulting in a loss of control.

Liquidity

Debt investments are generally more liquid than equity investments, especially if they are short-term loans. This means that debt investors can more easily access their money and withdraw their investment if needed. Debt investments also tend to have a shorter holding period, usually no more than a couple of years, which contributes to their liquidity.

On the other hand, equity investments are often very long-term, sometimes lasting as long as ten years. They are considered illiquid, especially if there is no early redemption programme in place. Equity investors may struggle to withdraw their money early and may have to wait a significant amount of time to see a return on their investment.

The liquidity of an investment is an important factor in determining its level of risk. More liquid investments, like debt investments, are often seen as lower risk because investors have quicker and easier access to their money. Conversely, the illiquidity of equity investments adds to their risk.

However, it is worth noting that while debt investments are more liquid, they may still come with a level of risk. There is no guarantee that borrowers will make their payments, and if they default, debt investors will be paid off first, but they may still lose money.

Overall, debt investments offer greater liquidity, which can be attractive to investors who want easier access to their money and lower risk. Equity investments, with their lack of liquidity, are riskier but offer the potential for higher returns over the long term.

Tax implications

Debt Financing

Debt financing involves borrowing money, which can be done by taking out a loan or issuing bonds directly to investors. The interest payments made on these loans are deductible as ordinary business expenses, lowering the overall cost of financing. Businesses can also deduct interest on loans at below-market rates, which are subject to “imputed interest"—the interest that the IRS assumes has been paid and is taxable whether it has been paid or not.

Equity Financing

Equity financing involves selling a portion of a company's shares in exchange for capital. This type of financing is less favourable from a tax perspective as dividend payments and the return of capital are not deductible to the business. In C corporations, equity financing costs are taxed twice: once on the corporation's business return and once when dividends are distributed to investors.

Other Considerations

When deciding between debt and equity financing, businesses should also consider the current and future net inflows and outflows of cash. If a business doesn't expect additional capital to increase profits for many years, equity financing may be preferred as funds don't have to be repaid, and interest doesn't accrue. On the other hand, debt financing may be preferred if a business wants to avoid diluting the shares of ownership.

Debt-to-Equity Ratio

The debt-to-equity ratio shows how much of a company's financing is provided by debt and equity. A relatively low debt-to-equity ratio is considered favourable by creditors, which can benefit the company if it needs to access additional debt financing in the future.

Tax on Debt Investments

In the context of tax on debt investments, fixed deposits are a popular option as they offer assured returns, high liquidity, and ease of investment. While deposits of 5 years and above are tax-deductible, the interest earned is taxed at one's marginal tax rate. Senior citizens may be exempt from this up to a certain amount.

Tax on Equity Investments

Equity-linked savings schemes (ELSS) are a good option for saving on tax and earning higher long-term returns. ELSS has the lowest lock-in period compared to other tax-saving instruments, and there is no cap on the investment amount. An investor can claim a tax deduction of up to a certain amount under Section 80C.

Tax on Hybrid Instruments

The National Pension Scheme is an ideal investment tool for retirement planning. It is market-linked but less volatile than mutual funds due to its asset mix of equity, government debt, and corporate debt. Investors can claim a tax deduction of up to a certain amount per year under Section 80CCD, in addition to the benefit available under Section 80C.

Investor rights

Debt Investment

In a debt investment, the investor acts as a lender to the business. The investor provides a loan to the business, and the business promises to pay back the loan amount with interest. The investor has the right to enforce the terms of the agreement in court if the business fails to uphold its end of the deal.

Debt investments are generally considered lower risk than equity investments. In the event of bankruptcy, debt investors are the first to be paid back. The loan is secured by the company's assets, which can be used as collateral. This means that if the business defaults, the investor can take control of the assets and recoup their investment through foreclosure.

Debt investments usually have a fixed rate of return, determined by the interest rate on the loan and the amount invested. This provides a steady and predictable income, with monthly or quarterly payments. However, debt investments have a capped return due to the set interest rate, and there may be significant fees associated with debt investment crowdfunding.

Equity Investment

In an equity investment, the investor acts as a shareholder and part-owner of the company. They purchase a portion of the company's equity, giving them a stake in the business proportional to their investment. Equity investors have a right to a prorated amount of the company's profits, known as dividends. They may also receive payments if the company is sold and the assets appreciate in value.

Equity investments offer the potential for higher returns, with no cap on returns. If the company performs well, the value of the investor's shares may increase, leading to greater profits. Equity investors can also influence the company's operations and decision-making, especially if they acquire a significant portion of the company.

However, equity investments come with a higher risk. If the company performs poorly or fails, equity investors may lose their entire investment. In the event of bankruptcy, debt investors are paid before equity investors, reducing the likelihood of recouping their investment. Equity investments also typically have a longer hold period, which may affect the liquidity of the investor's portfolio.

Comparison

Debt investments provide more stable and predictable returns, with lower risk and a shorter hold period. On the other hand, equity investments offer the potential for higher returns but carry a greater risk of loss. Equity investors have more control over the company but must share profits and consult with other investors. The choice between debt and equity investment depends on the investor's risk tolerance, liquidity needs, and investment goals.

Frequently asked questions