Debt vs. Equity Financing

If you are a business owner, you need to gain capital to grow. Your two options available are debt or equity financing. In this article we are going to deeper into what they are, so you know which one is right for your business and your goals.

What Is Debt Financing?

Debt financing is borrowing a fixed amount from lender which is then paid back with interest. If you have ever taken out a loan, you have used debt financing. Other examples include business lines of credit, business credit cards, short-term loans, SBA loans, and bank loans.

The Pros of Debt Financing

  • Full business ownership: you get to make all the decisions and keep all the profits of your business.
  • Tax deduction: the interest you pay on a loan is considered a business expense. You can deduct this from your income and save money when doing your taxes.
  • Short-term obligation: you will have no obligation to the bank or whomever you borrowed money from once you repay it.
  • Easy access: no matter what industry you are in or your time in business, there are a wide variety of financing options available.
  • Flexible: debt financing is flexible. There are many other kinds of business loans with wide ranges in how much money you will get and how long you will make repayments.

The Cons of Debt Financing

  • Repayments: you will need to repay your lender even if your business does not succeed like you had planned. This is stressful for those who are startups because you do not know if you will be able to make your repayments.
  • High interest rates: if your credit score is low, you will be facing high interest rates that will cost hundreds and even thousands over the life of your loan.
  • Risk of collateral: you may have to use collateral when you obtain debt financing. Collateral puts the lender at ease because in the case you default on your payments, the lender can seize your asset.
  • Your credit is affected: if you do not make timely payments of your loan, your credit may be affected. This makes it difficult to get financing in the future or you will not be able to get favorable terms and rates.
  • Cash flow: if your business experiences cash flow fluctuations each month, debt financing can be risky because you may not be able to make the monthly payments on the loan.
  • Certain restrictions: depending on the lender you choose; they may have certain restrictions on what you can and cannot use your loan for.

What Is Equity Financing?

Equity financing is where you trade ownership of your business in return for their capital. To obtain equity financing you can get it through a venture capitalist, angel investors, and family and friends.

Venture capital firms invest in entrepreneurs and new, fast growing businesses. They do have strict rules so they may not be the best for every small business looking for financing. Angel investors put money into startups and small businesses to help grow your business rather than making a profit from it. Friends and family may be willing to offer you some cash to help invest in your business venture. However, you do run the risk in affecting your relationship with them in the case that your business does not succeed.

The Pros of Equity Financing

  • No repayment required: you do not have to repay a loan with interest and fees. This will let you hang on to the capital you have and reduce the risk of cash flow problems.
  • Business advice: your investor may connect you with others in your industry to help you expand your knowledge and business.
  • Large funding: investors provide large funding amounts which can be a big advantage for your business.

The Cons of Equity Financing

  • Loss of ownership: you will no longer be the sole owner of your business and you will not keep all your future profits.
  • Investors are controlling: investors have the power and they may make decisions that you may not agree with.
  • Time consuming: pitching investors can take some time and they make require a thorough business plan.

How to Choose?

Now that you are informed of how debt and equity financing work, you may be wondering which one is right for you. If you have smaller capital needs and prefer to not give up ownership of your business, stick with debt financing. If you need large amounts of capital and are okay with giving up some ownership, equity financing may be for you. There are pros and cons to both but understanding which may be the most beneficial for your business will help you choose.