There are 2 types of outside financing small business owners can consider when they need capital.
Debt financing involves borrowing a sum from a lender that has to be paid back with interest. Equity financing involves selling stakes of your company to an investor in exchange for capital.
Here is a brief overview of debt vs. equity financing:
Deciding between debt or equity financing will depend on your business needs.
What Is Debt Financing?
If you’ve ever taken out a loan, you’ve used debt financing. This is when you borrow a set amount of money and pay it back with interest over a set period of time.
Debt financing encompasses a broad category of loan types.
- Bank loans
- Small Business Administration (SBA) loans
- Business lines of credit
- Business credit cards
- Short-term loans
Pros and Cons of Debt Financing
Debt financing doesn’t require owners to give up any shares or control, but the loan application process can prove challenging. The necessary requirements and documentation will vary based on the lender.
Advantages of Debt Financing
- Available to businesses of any size
- Fast turnaround
- Flexible use of funds and loan terms
- Wide range of funding amounts
- Set repayment terms
- Liability limited to loan term
- Tax-deductible interest payments
- Can build business credit
- Retain ownership
- Lender can’t request shares of future profits
- Lender doesn’t have control of business management
- No investor reports or shareholder meetings required
Disadvantages of Debt Financing
- Some borrowers may not meet credit score requirements
- Financial standing may impact borrowing limit, rates and fees
- Collateral may be required
- Debt service payments cut into business revenue.
- Repayment, including principal and interest, is required regardless of business success
- Failure to repay the loan could lead to business or asset liquidation
- Taking on too much debt could hurt business valuation and hamper future financing
What Is Equity Financing?
Equity financing involves reaching out to external investors for money so you can sell company shares in exchange for capital. Investors can offer shared partnerships, expertise and financial stability.
Examples of equity financing include:
- Angel investors
- Venture capitalists
Crowdfunding for Your Small Business
Crowdfunding refers to the process by which an interested collective of parties contributes money (usually via an online platform) to fundraise for a cause or business. In return, crowdfunders usually receive a small benefit, such as a prototype of the product or other exclusive items or services.
By definition crowdfunding doesn’t involve incurring debt or giving up equity, so it isn’t necessarily debt financing or equity financing.
Pros and Cons of Equity Financing
The big trade-off with equity financing is giving up an ownership stake in your business in exchange for capital. Repayment comes in the form of refinancing, a business sale or other means.
Advantages of Equity Financing
- Larger amounts of capital
- Risk passed on to investors
- Collateral isn’t required
- Revenues aren’t diverted to repayment
- Interest isn’t required on capital
- Immediate returns on investments aren’t expected
- Involved investors can serve as business mentors
- Repayment isn’t required if business fails
Disadvantages of Equity Financing
- Giving up a portion of company ownership
- Reduced autonomy
- Investors can influence business decisions and culture
- Pitching investors can be time consuming
- Slow approval process
- Potential investors require a thorough business plan
- Longer turnaround time to receive funding
- Smaller share of ownership can reduce your share of profits
- Investors can force original owners to cash out
Debt and Equity Funding: Which is Right for Your Business?
The difference between debt financing and equity financing comes down to taking on debt or sharing stakes in your business. But there are other factors to consider when weighing debt financing vs. equity financing. Here are 5 questions to ask yourself:
1. How Fast Do You Need Funding?
Thanks to online lenders, you can receive an influx of cash through debt financing in as little as a day. Equity financing is a more involved process that requires pitching and negotiating with investors.
2. How Much Money Do You Need?
With equity financing, investors will give you large amounts of capital in exchange for a business stake. With debt financing, maximum funding amounts will vary but you can receive a small influx of cash— without giving up equity—to meet your business needs.
3. Do You Have a Short- or Long-Term Need for Capital?
Depending on the type of funding, debt financing can be repaid within months. Equity financing, however, is more about the long game and investors don’t usually expect to see returns for years at a time.
4. Do You Need Other Forms of Business Support?
Debt financing is a transactional relationship between your business and your lender. With equity financing, there is the potential to form close relationships with investors, who can offer advice or help with networking.
5. What Are Your Growth Plans?
If you’re OK with giving up complete control of your business in and see your company becoming a major, nationwide player, equity financing may be best for you. If you want to keep your business for yourself and find success in a niche market, debt financing may be the better fit.
The Bottom Line on Debt and Equity Financing
Ultimately, the advantages and disadvantages of debt and equity financing will impact your business differently based on your needs.
Once you know where you stand, you can choose the path that’s best suited for your business needs—and secure financing for long-term success.