Unless you have a hoard of generational wealth to build on, you will need to secure funding to start your own business. Business financing options include crowdfunding, angel investors, bank loans, and venture capital. However, the plethora of options often makes it difficult for businesses to choose between debt and equity financing.
A business needs to raise capital to fund the various activities that are essential to achieve its targets. In order to raise money, businesses mainly have two major types of financing options- Debt Financing and Equity Financing. While most companies combine both, there are distinct pros and cons to both.
The debate of Debt financing vs equity financing has been going on for decades. Companies and business owners have been struggling with this dilemma for years and quite honestly the answer is that it depends.
In this blog, we will provide information on both equity and debt financing with their definition, pros and cons, and which is the better option for you.
Let’s dive in.
- What is Debt Financing?
- Types of Debt Financing
- Advantages and Disadvantages of Debt Financing
- What is Equity Financing?
- Types of Equity Financing
- Advantages and Disadvantages of Equity Financing
- Difference Between Debt and Equity Financing
- Debt Financing vs Equity Financing: What to Choose?
- Frequently Asked Questions(FAQs)
What is Debt Financing?
I’m sure you are familiar with loans. Debt financing is essentially the same thing. Debt financing means borrowing money in the form of loans and paying it back with interest, often with strict conditions and agreement. If debt conditions are not met, there are severe consequences for the company and its owners. However, it is also one of the best ways to fund your business without surrendering your ownership rights.
The borrower accepts funds from an external source and promises to repay the principal with interest. Usually, the interest rate and the due date of the debt are discussed and decided beforehand. Borrowers will put up some valuable assets as collateral as reassurance to the lender and start making monthly payments towards both the principal amount and the interest.
While it may seem like a relatively bad thing, there are also numerous advantages to choosing debt financing. For instance, the interest you pay is tax-deductible, the lender has no rights over your business, and once you successfully repay the loan, your relationship with the creditor ends. Also, it is quite easy to track expenses as loan payments remain the same and don’t fluctuate.
Types of Debt Financing
There are several options when it comes to debt financing. Here are some of the most common ones-
Business Credit Cards
They are similar to personal credit cards but have distinct features that are tailored towards businesses and owners. These features include spending rewards that most business credit lines lack.
Traditional Bank Loans
While it can be hard to obtain a traditional bank loan to fund your business, they often have lower interest rates and APRs than loans from independent lenders and other external sources.
Merchant Cash Advances
Merchant cash advances have unusually high APRs and can be defined as a loan from an external lender that is repaid from your credit and debit card sales.
SBA stands for Small Business Administration and is one of the most popular choices for business owners seeking financing. Although the requirements for approval are quite strict, the SBA offers loans through banking partners with relatively lower interest rates and longer terms.
Lines of Credit
Lines of credit provide business owners with a lump sum of money. You can draw money whenever you are in need and are only required to pay interest on what you use. Moreover, unlike traditional bank loans, there are no collateral requirements in lines of credit.
Advantages and Disadvantages of Debt Financing
Much like most forms of financing, debt financing also comes with its own share of pros and cons. Let’s take a look-
Advantages of Debt Financing
Clear and Finite Terms: Debt financing provides clear and finite terms. You will know how much you owe, how long you owe it, and when you owe it. All the terms of repayment are transparent and the payment amounts will not fluctuate each month.
No Surrendering of Ownership Rights: Even though lenders will be familiar with your business operations, they will have no say whatsoever over your day-to-day operations. One of the best advantages of debt financing is that you don’t have to give an ownership stake to the lenders.
Tax-deductible Interest Payments: Another popular benefit of debt financing is tax-deductible interest payments. Yeah, you heard right. When it comes to paying taxes, you can deduct your debt interest payments from your taxable income and save plenty of money.
Disadvantages of Debt Financing
Here are some of the cons of debt financing. Keep reading to learn more-
Repayment and Interest Fee: While you will be aware of the terms of your loan, the repayment and interest fees can be quite steep in debt financing.
Instant Repayments: In debt financing, you will be required to start making payments from the first month after the loan has been credited. It can be a challenging endeavour since most businesses don’t have a secure financial footing this early in the company’s lifespan.
Potential for Financial Losses: In case you fail to repay your loan, you can incur potential personal financial loss. Failure of repayment can have several consequences including a negative impact on the credit score, loss of collateral, and loss of personal property or business assets. In extreme cases, it can be catastrophic and may result in bankruptcy.
Now that you have a general idea about debt financing and its pros and cons, let’s learn about what is equity financing.
What is Equity Financing?
Unlike debt financing, equity financing is the process of raising capital by selling the company’s shares. The proportion of ownership provided to the financier ultimately depends on the amount invested in the company. There are various ways to obtain equity financing including approaching a venture capitalist or equity crowdfunding.
Most companies prefer equity financing as the investor bears all risk in case of bankruptcy or business failure. If the company fails, the investor also incurs losses. However, with equity financing, the investor is closely involved in the operations of the company and has an equal say in business matters.
Besides an ownership share, the investors also get the promise of future profits in the company. However, this depends on the investor. For instance, some investors are satisfied with the ownership share, some are interested in the receipt of dividends, and some investors are happy with the appreciation of the share price of the company.
Types of Equity Financing
Much like debt financing, there are various ways to obtain equity financing-
A venture capitalist is a group or individual that usually invests money in high-risk startups. They are attracted to the startup’s growth potential and may be interested in buying the company or an ownership share in the long run.
An angel investor is a high-net-worth individual that provides investment to startups and companies. Often, angel investors have no interest in the operations of the company and only care about long-term profits. In return for their investment, they get an ownership share in the company or convertible debt for their investment. They are often hard to acquire as they don’t just throw money at any project and are experienced investors. To attract an Angel investor to invest in your company, you need a unique idea with a solid executable plan that promises great returns.
Equity crowdfunding is the selling of minority shares of the company to multiple investors via crowdfunding platforms. These are usually hard to get as they require extensive marketing efforts and a lot of groundwork to achieve your goals.
Advantages and Disadvantages of Equity Financing
There are various pros and cons to equity financing. Let’s take a look-
Advantages of Equity Financing
Suitable for High-growth industries: For venture capitalists and angel investors, a startup that ensures rapid growth in a profitable industry is the best candidate for equity financing. Both types of investors are usually interested in profits and only invest in startups that have solid operational plans and goals that promise hefty returns.
Quick Scaling: It is easiest to quickly scale with equity financing as you get access to a huge amount of capital to fund your business. It is also the preferred choice for most business owners as investors bear all risk in case of business failure.
No Repayment in Case of Loss: While debt financing requires you to repay the loan even if your business fails, equity financing waits until you can make profits from your business. If your business is profitable, you can share a percentage with your investors. However, if the business fails, you are not liable to pay back angel investors or venture capitalists.
Disadvantages of Equity Financing
Difficult to Obtain: Unlike debt financing where you can approach a lender and apply for a loan, equity financing is relatively harder to obtain. It requires a strong network with investors, a unique business idea, and a strategic business plan to make your business profitable.
Investors are Involved in Business Operations: Since equity financers receive an ownership share in the company in return for their investment, they have an equal say in your business operations and crucial business decisions. If you surrender more than 50% of your shares, whether to multiple investors or just one, you will lose your majority share in the company. It basically means you have less control over your company’s operations and you may even risk losing your managerial position if the other shareholders decide to change leadership.
Potential for Larger Payments: While debt financing payments are fixed and don’t fluctuate, you may end up paying your investors more than your loan payments in some cases.
Difference Between Debt and Equity Financing
While both are ways to acquire capital for your business, there are distinct differences between debt and equity financing. Let’s take a look at equity vs debt financing.
- While debt financing is borrowing capital to fund your business, equity financing involves selling your company's stock to investors in exchange for funds.
- Debt financing can be obtained through bank loans, mortgages, credit cards, overdrafts, and other external lenders. Whereas, the sources of equity financing include angel investors, venture capitalists, equity crowdfunding, corporate investors, and retained earnings.
- In comparison, equity financing is relatively less risky than debt financing. While businesses offer an ownership share to the investors, they are not required to pay them back in case of business failure. The investors are also held liable for losses. However, business owners have to pay back the loan even if the business fails in debt financing.
- In debt financing, the investors have no right or say in the day-to-day business operations. However, equity financing provides an ownership share to the investor depending on their contribution to the company. They also get voting rights in business matters and can influence business operations.
Read Also:- Does Bankruptcy Clear Bank Debts?
Now that you have a general idea about debt financing vs equity financing. Let’s see how they both compare with each other across different parameters.
Parameters of Debt Financing vs Equity Financing
|Borrowing funds from lenders without relinquishing ownership rights.
|Funds raised by the company by selling ownership shares to investors.
|Debt or Liability?
|Debt financing is a type of loan which is a liability for the company.
|Equity financing is a type of asset to the company.
|Debt financing is a short-term finance for the company.
|Equity financing is a long-term finance for the company.
|Debt financier is a lender to the company and has no say in business operations.
|The shareholder of the company is the owner of the company and has voting rights.
|Debt is a low-risk investment.
|Equity is a high-risk investment
|Term Loans, Debentures, Bonds, etc.
|Stocks and Shares
|Lenders are repaid the principal amount along with interest.
|Shareholders get a dividend of the profit depending on the ratio of shares of profit earned by the company.
|Nature of the Return
|The loan payments are fixed and don’t fluctuate monthly. They are also mandatory.
|Dividend paid to the shareholders vary as it is dependent on the profit earned by the company.
|Requires a collateral to provide reassurance to the lender. However, some lenders also offer funds without any collateral.
|No collateral is required as investing in a company provides ownership rights to the investor.
Debt Financing vs Equity Financing: What to Choose?
The debate for equity vs debt financing is complex as the answer depends on various factors like type of business, size of operation, capital structure, market conditions, risk-taking ability, customer base, future projections, etc. If you are torn between the two, we suggest conducting a proper analysis of the above-mentioned factors and comparing them with the basic characteristics of both options to choose the one most suited to your business needs.
While debt financing will help you retain ownership and reduce the tax burden, it also brings up the liability of paying back the lenders. Whereas Equity financing dilutes ownership but there is no pressure of repayment. Moreover, the company doesn’t have to face any legal trouble in case of bankruptcy.
It is important to study the market and identify the position of the company to choose the best approach. You can also consult financial advisors and experts to figure out the best option for you. Remember, there is no right answer and it ultimately depends on various factors including the position of your company in the market. Take your time and conduct a thorough analysis before making this crucial decision.
Frequently Asked Questions(FAQs)
Ans. A company should choose debt financing over equity financing if it is not willing to relinquish a part of its company. If you want to acquire funding without giving up ownership rights, debt financing is the best option for you. However, you must be sure to make repayments timely or you might risk losing your collateral or in extreme cases, file for bankruptcy.
Ans. It depends on the status of your company and financial condition. Debt financing can be riskier if you fail to make profits and repay your lenders. However, equity financing can be riskier if your investors expect you to turn healthy profits(which they usually do). If they are unhappy with your performance, they might try and negotiate for cheaper equity or in extreme cases, remove you from the managerial position.
Ans. It depends on your business and its performance. In some cases, debt can be cheaper than equity, however, the opposite is also true in some cases. If your business is not profitable and you declare bankruptcy, you are not liable to pay back your equity investors. However, you still need to pay back the loan plus interest. In this case, equity financing is cheaper.
If your company sells for a staggering amount of money, the amount you will have to pay the shareholders can be more than paying off the entire loan. In this scenario, debt financing is cheaper. Each circumstance is different and it ultimately depends on your business and profitability.