Debt vs. Equity Financing: What Option Is Best for You?

Are you a small business owner looking for the best way to finance your business? You may have heard of debt and equity financing, but what’s the difference, and which option is better? Companies typically choose between debt vs equity financing when seeking to raise funds. 

Debt and equity finance are typically used together, but each has its own benefits. Equity financing may be utilized to expand a company’s operations without incurring any debt. To obtain debt funding, on the other hand, it is not necessary to sell any equity.

Borrowing money and then paying it back with interest is an example of debt financing, and it’s a common way for new businesses to get started. Obtaining equity financing means obtaining capital from investors in exchange for a stake in the company.

There is frequently a choice between debt vs equity financing for businesses. The liquidity of the business, the availability of alternative funding options, and the importance of company control to the company’s key shareholders are all factors to consider while making this decision. The debt-to-equity ratio measures the relative contributions of debt and equity in funding a business.

In this article, we break down debt vs. equity financing, discuss their pros and cons, and help you decide which financing route is right for you.

Equity Financing vs. Debt Financing: What’s the Difference?

The main difference between debt vs equity financing is that debt financing is borrowed money that must be paid back, while equity financing is an investment in the business.

When it comes to debt financing, usually, you must pay interest on the loan and repay the debt within a certain term. Businesses will typically take out a loan from a bank or other lender. A few examples of debt financing include credit cards, lines of credit, and term loans.

On the other hand, with equity financing, a business can receive capital from venture capitalists or angel investors, or use crowdfunding and sell a percentage of the company to a third-party investor in exchange for capital.

Detailed Difference Between Debt vs Equity Financing

• Obtaining Funding for a NewStartup. Since startups typically have a shorter history, equity financing may be preferred over debt financing. Equity investors are more likely to take a chance than lenders.

• Obtaining Funding as an Established Business. When a company reaches a certain level of development, it may be easier to raise debt vs equity financing. One reason for this is that an established firm’s past successes can be more easily demonstrated. 
  
  In addition, if the rate of growth for either the firm or the industry has slowed, an equity investor may not view a mature company as a desirable investment.

• Quickness in Obtaining Funds. In a matter of days or weeks, a small business might be able to secure loan funding. Procuring equity finance could take more time if the owner and investor need to negotiate terms like the investor’s percentage of ownership.

• Amount of funding. When compared to debt financing, the pool of money available to a small business through equity financing is usually larger. Equity funding can be in the millions of dollars, whereas the maximum amount you can borrow on debt is probably about $100,000.

• Repayment. Debt financing, such as a loan, must be repaid in full plus interest by the borrower within a predetermined time frame. Because you’re taking out a loan to do so. However, equity financing does not necessitate repayment.

• Profits. A financing contract normally does not include profit sharing, while an equity investor may require a cut of future earnings.

• Ownership. Small business owners who accept equity financing do so in exchange for a portion of the company’s future profits. When obtaining debt finance, a small firm does not have to give up any control over the company.

• Seat on Board. In exchange for financial backing, equity investors will often demand representation on a company’s board of directors. However, board membership is never part of a debt financing agreement.

Debt Financing vs. Equity Financing for Small Business

When deciding on debt vs. equity financing, there are definitely benefits to both options.

Debt financing is an option for small business owners because it does not require them to give up any ownership in their firm to do so. As a result, the owner keeps complete control of the business and the loan is usually collateralized by the company’s assets. 

Small business owners can keep their cash flow steady and use the borrowed money for other purposes when they obtain debt financing. One potential drawback of debt financing is that new enterprises with no established credit history may have a more difficult time qualifying for a loan.

Here are some of the most typical kinds of loans for smaller businesses to consider if you need to borrow money to fund operations.

• Loans with a fixed repayment schedule: If you’re aiming to grow and have solid revenue and credit, a term loan could be an excellent option.

• Business lines of credit: A business line of credit is an adaptable source of funds for unexpected expenses, such as those incurred when stocking up on supplies or repairing broken machinery.

• Invoice factoring: Since the invoices themselves serve as collateral, invoice factoring may be a possibility for startups with low credit scores.

• Business credit cards: If you’re just starting off and can’t get a loan, a business credit card can be a lifesaver for paying the bills every month.

• Business personal loans: For start-ups that would rather not risk diluting their stock, personal loans are an alternative; nevertheless, interest rates will vary greatly depending on the borrower’s creditworthiness.

Equity finance is another option for giving a small company a financial boost. Investors may provide a company with more than just financial backing; they may also provide their knowledge and connections in the industry. 

Some investors may have little say in the daily operations of the business, depending on the nature of their investments. Alternatively, equity financing requires the business owner to sell a portion of the company, which may be a costly and time-consuming process.

The following are examples of equity-based funding for small businesses:

• Venture capital: Any number of entities, from individuals to corporations, might be potential sources of venture capital. Venture capitalists are more inclined to back established businesses than startups but in exchange for stock and a board position.

• Angel investors: Angel investors are private individuals who invest their own money in startups. They are more inclined to take a chance on a business if the expected return on their investment is substantial.

• Family and friends: It can be challenging to gain the attention of a venture capitalist or angel investor, and even more so to convince them to invest. Attempting to raise equity funding from close associates or relatives may prove more fruitful. However, if you end up losing their money, your friendship may suffer.

Conclusion

When it comes time to raise funds, businesses can turn to either equity financing or debt financing. Debt financing entails taking out a loan, whereas equity financing calls for selling a stake in the business. However, the potential drawbacks of equity financing are substantial despite the fact that the company incurs no additional costs.

There are benefits and drawbacks to both types of funding, debt, and equity. The most significant benefit of equity financing is that there is no need to make any payments toward the money you’ve borrowed. The primary benefit of debt financing is that the business owner does not have to give up any ownership stake in the company, unlike equity financing.

Which option is better depends on your specific circumstances, including your business’s size and present status? Weigh your options thoroughly and locate a reliable financial partner before making any final calls.

Securing capital through either debt vs equity financing is not a one-size-fits-all solution for any small business. If, for example, a small business needs access to funds quickly, debt finance may be the best option. Alternatively, if your company needs a larger sum of capital, equity financing may be the way to go because equity deals tend to be larger than debt deals.

Talk to professionals you trust, including an attorney, accountant, and advisors. In this way, you will figure out which financing option is appropriate for your small business.

FAQs

1. What is debt financing?

Debt financing is interest-bearing loans. Credit cards, lines of credit, and term loans are common sources of debt financing.

2. What is equity financing?

Equity financing involves selling a percentage of the company to an investor in exchange for capital. This can be in the form of venture capitalists or angel investors, or from crowdfunding.

3. What are the advantages and disadvantages of debt vs. equity financing?

To put it simply, the main benefit of equity financing is that there is no need to repay the money. However, unlike equity financing, the benefit of debt financing is that the business owner retains full control over the company.