Introduction

Entrepreneurs and business owners often face the critical decision of choosing between debt financing and equity financing. Debt financing, such as loans and bonds, typically comes with lower costs compared to equity financing, such as stock issuance. This article explores the two primary reasons why debt financing can be less costly than equity financing, and delves into the details of these reasons.

Lower Cost of Capital for Lenders

The first key reason why debt financing is less costly than equity financing is the lower cost of capital for lenders. When equity providers, such as investment funds, offer capital to a project, they are taking on the risk of investing in a potentially high-risk venture. These equity providers expect a mid- or high-double-digit return on their investment to justify the risk and the opportunity cost of their money. Consequently, these funds must charge high rates to cover the cost of this risk. Lenders, on the other hand, often come from regulated depository banks which obtain their capital from depositors. These depositors are entitled to a lower interest rate, thanks to government deposit insurance, and the bank does not have to pay much interest to retain these deposits. As a result, the cost of capital for lenders is much lower, allowing them to provide financing at single-digit rates.

Structural Subordination: Priority of Repayment

The second primary reason for the lower cost of debt financing is the structural subordination of loans. Loans are typically arranged to prioritize loan payments over the payment of equity dividends. In the event of a bankruptcy where insufficient funds are available to be distributed, loan payments are generally given priority over equity dividends. The law generally offers preferential treatment to lenders over equity stakeholders. This structural protection minimizes the risk for lenders, thereby justifying their lower required returns compared to equity stakeholders who are taking on higher risks.

Conclusion

In summary, the lower cost of capital for lenders and the structural subordination of loans are the two main reasons why debt financing can be less costly than equity financing. Understanding these factors can help entrepreneurs make more informed decisions about which type of financing is most suitable for their needs. Furthermore, maintaining a high level of ownership and finding the right investors, such as long-term investors or angel investors, can also impact the cost and success of financing your venture.