Finwonk
Finance from zero4 min read

Debt vs equity: who funds a company

The interview question

“What's the difference between debt and equity?”

Valuation, LBOs and M&A all hinge on who has a claim on the company and in what order. This is the root of all of it.

The core idea

Lenders get a fixed claim, paid first. Shareholders get whatever's left, which can be nothing or a fortune.

Two kinds of money

A company can borrow (debt) or sell ownership (equity). A lender is promised interest and their money back on set dates, whatever happens. A shareholder is promised nothing, but owns a slice of every future profit.

If things go badly, lenders are repaid first; shareholders get only what's left. Because lenders take less risk, they accept a lower return, and interest is tax-deductible. That makes debt the cheaper source of money, until there's so much of it that a bad year means missing a payment.

Worked example
A company worth $1,000 with $400 of debt.
  1. 1Shareholders' slice = $1,000 − $400 = $600.
  2. 2If the company becomes worth $1,500: lenders still get $400; shareholders get $1,500 − $400 = $1,100.
  3. 3If it falls to $300: lenders take all $300; shareholders get $0.
Debt has a fixed claim. Equity takes every gain and absorbs every loss.
See the bridge
600
+400
1,000
Equity value
+ Debt
Enterprise value
The whole business is split between lenders and shareholders. This bridge reappears in valuation.
Banker tip

Preferred stock sits in between: paid after lenders but before common shareholders, usually with a fixed dividend.

Say it like this

Debt is borrowed money: lenders get fixed interest and repayment and are paid before anyone else, so they take less risk and accept a lower return. Equity is ownership: shareholders get whatever value is left after lenders, with unlimited upside but the first losses. Debt is usually cheaper, especially because interest is tax-deductible, but too much of it raises the risk of default.

Traps to avoid

  • ✕Saying equity is cheaper because it doesn't have to be repaid. Shareholders expect a higher return than lenders.
  • ✕Forgetting the tax deduction on interest.
  • ✕Ignoring dilution: issuing new shares shrinks existing owners' percentage.

What they'll ask next

›Why not fund a company entirely with debt?

Fixed payments would be impossible to meet in a bad year, and lenders would demand ever-higher rates as the risk grows.

›What does issuing new shares do to existing owners?

It dilutes them: they own a smaller percentage, though possibly of a bigger, better-funded company.

›What's an interest tax shield?

The tax saved because interest is deducted before tax: interest × tax rate.

Check yourself

Question 1 of 3

If a company is wound up, who gets paid first?