Unsure about the difference between debt and equity financing? If you’re a small business looking for capital, you might consider taking out a loan (debt) or looking for an investor (equity).
Let’s explore debt vs. equity financing to ensure you’re leveraging the right financial tools for your business.
Debt financing involves borrowing a sum from a lender that has to be paid back with interest.
A pro of debt financing is that you’re in control of how the capital is spent. Though some lenders impose restrictions, what you do with your funds is up to you. In other words, you’re not limited by your investors’ interests.
Examples of debt financing include:
With equity financing, you’re selling shareholders stakes in your company. In exchange, you receive capital for business expenses and expansion.
Equity financing is a serious matter you should explore in-depth because you are selling ownership rights.
Examples of equity financing include:
- Angel investors
- Venture capitalists
We’ll take a look at debt and equity financing in detail to help you make informed decisions for your business.
What Is Debt Financing?
If you’ve ever taken out a loan, you’ve leveraged debt financing. You borrow a set amount and pay it back with interest. Your business will have capital to cover operating costs and can spread repayment over an agreed term.
Debt financing encompasses a broad category of loan types. There are many funding options a business owner can consider, including lines of credit and term loans.
Be sure to explore your options and select the debt financing that best fits your unique capital needs. For example, while a term loan is a good fit for long-term growth initiatives, such as opening a new space, a line of credit is a better choice for entrepreneurs with short-term and revolving capital needs.
What Are the Advantages of Debt Financing?
According to the U.S. Small Business Administration, small business owners borrowed an estimated $600 billion in 2017. This makes debt one of the most popular and accessible forms of financing.
To understand why, let’s take a closer look at debt financing benefits:
- Debt financing is accessible to businesses large and small.
- Your lenders can’t claim equity in your business. The debt doesn’t dilute your ownership interest.
- Your lender can’t request shares of future profits or control how you run your business.
- You can request small amounts of capital.
- If you’re financials are correct, you can receive funding within 24 hours.
- You don’t have to file reports with investors or hold shareholder meetings.
- You can avoid added expenses associated with mailings and filings.
- You can limit your exposure to audits.
- Interest payments are tax deductible.
- Debt financing builds business credit.
What Are the Disadvantages of Debt Financing?
The loan application process can prove stressful if your business is struggling to break even. And, if you don’t have a finance background, it can be hard to generate accurate financial records and forecasts the bank needs.
Other drawbacks include:
- Your business must qualify for a loan. You have to prove you will make enough income to pay back the debt and meet day-to-day costs.
- You might not qualify if you don’t have strong financials and a good credit score.
- You may need to pledge business or personal assets to secure the loan.
- You may have to liquidate assets and close your business if you don’t repay your loan due to cash flow problems.
- Your loan has to be repaid and accruing interest will affect your break-even point.
- Your loan has to be repaid regardless of whether you made a profit.
- Your debt-equity ratio might affect how much you can borrow and it can affect repayment terms.
- You’ll have to use part of your revenue to pay your debts. And, carrying too much debt makes you high risk to equity investors.
- With a limited loan, you might not have the resources to capitalize on future growth opportunities.
What Is Equity Financing?
Equity financing involves reaching out to external investors for money. You sell company shares in exchange for capital.
Businesses that use equity financing usually aspire to become a global brand or national chain. They turn to investors for shared partnerships, investor expertise and financial stability.
Not sure what potential investors look for? Here is additional information on equity financing that can help.
What Are the Advantages of Equity Financing?
There’s more to equity financing than merely securing a deal and walking away with cash in your hand. Selling an ownership stake in your business comes with benefits and advantages that many first-time entrepreneurs don’t immediately realize.
- Money doesn’t have to be paid back to investors if the business fails.
- Investors that are mentors can help cultivate better working partnerships. You can leverage their experience and industry connections.
- You don’t pay interest on the capital, and your profits don’t go into debt repayments.
- Equity financing does not require you to pledge assets as collateral, or a personal guarantee.
- Businesses in any industry can tap into equity financing.
- Equity investors have the long game in mind. As a result, they do not expect immediate returns on their investments.
What Are the Disadvantages of Equity Financing?
There are several reasons why you might not want to pursue equity financing.
- Equity financing isn’t for small amounts of capital.
- Potential investors want a complete business plan. They can reject you if your financials and sales forecasts aren’t accurate.
- If you’re new to the business, you might overspend on things like labor and marketing. You might also neglect to budget for expenses as you have access to a larger pool of money.
- The approval process can be slow. You have to find investors, pitch ideas and draw up legal terms and conditions.
- You may have to give up full autonomy (your rights).
- Investors may focus more on decisions that will secure future profits. This lack of shared managerial vision can increase tension.
- Your investors can force you to cash out if they don’t agree with you because you’re giving up ownership rights.
- Another disadvantage is that you might lose money if you sell your company. Here’s an example. Let’s say your business sells for $10 million. If you used 20 percent of the business for equity financing, you would have to fork over $2 million of the proceeds to your shareholders. However, had you taken out a loan for $1 million, you wouldn’t forfeit these proceeds. You would merely have to pay back the loan.
Final Thoughts on Equity and Debt Financing
When weighing equity financing vs. debt financing, carefully consider the pros and cons. Study your financials and explore the amount of capital required to sustain your business and scale.
If you’re still undecided, consult with an accountant or business attorney who can assist you before making any final financial decisions.
Once you understand where you stand, you can choose the path that’s best suited for your individual needs—and secure financing for long-term success.