If you need an alternative funding source to provide additional financial support for your business growth, you might consider the differences between debt and equity financing. There are advantages and disadvantages to each financing option. Read on to learn which type of financing is right for your business.
What Is the difference between equity financing and debt financing?
The difference between debt and equity funding is simple; each has its pros and cons. Debt financing involves borrowing money to start or grow your business. On the other hand, equity financing refers to investors providing funds to a company for part ownership of the business (usually in the form of shares).
With debt financing, you must repay the funds in instalments, usually monthly, plus interest. However, equity investment has no repayment requirements. Instead, investors receive a return through dividend payouts or selling appreciating stocks.
Why does my business need financing?
Business owners need funds to grow and expand. Debt or equity financing is not just for startup businesses; any organisation might need funding throughout their lifetime, depending on its business plans. Here are a few reasons you might need debt or equity capital:
- To pay for basic needs when starting, e.g., business insurance or resources.
- To pay for equipment financing or repairs.
- To expand international trade and scale operations.
- To expand business premises.
- To pay for marketing and advertising costs.
How does equity financing work?
Equity finance refers to securing funding from investors. Unlike debt finance, equity can change the business structure. Types of equity financing include angel investors or venture capital firms.
Typically, an investor will provide funds to the company, who, in return, starts issuing equity. Equity means that the investors receive a percentage of ownership of the business investor in exchange for money. With a stake in your company, they can vote on and influence business decisions to ensure they get a return on their investment. We’ll cover the equity financing pros further on.
For instance, if a company owner needs to raise money to expand, they might decide to give up 10% ownership of the business. They sell to corporate investors in return for sources of capital. The investor then owns 10% of the business and has a say in the company’s future.
Equity financing options for small businesses
Here are some sources of equity finance to fund your business:
- Business angel investor: Accredited individuals who use their own money as a source of funding. They typically invest in startups with strong future profit potential and are, therefore, more likely to take a risk for a rewarding return.
- Venture capitalists: A firm or a single person investing from a pool of money. They are more likely to fund established businesses and will require a place on the board of directors.
- Initial public offering (IPO): Privately held companies may sell shares and stocks to an investor with an initial public offering.
- Family and friends: Asking friends and family to invest in your business might bring better luck, but you risk hurting the relationship.
How does debt financing work?
Debt finance means approaching a bank or financial institution for loans. Investment banking business loans accrue interest over time, which the business must repay over a set period. Other types of debt financing might include a line of credit or credit card.
Business loans work just like personal loans. You’ll need to get all your finances into good shape and boost your credit score to apply.
The bank may prescribe how to use the money — although this is less controlling than equity finance. They specify that you must use the funds for machinery or equipment. These are usually secured loans and use your purchase as collateral. However, you can also get unsecured loans that have higher interest rates.
Debt financing options for small businesses
If you want to use debt to fund your business operations, here are a few forms of debt to consider:
- Term loans: High-borrowing limit bank loans are a good option for businesses looking to expand. You’ll need a good credit score and evidence of strong earnings.
- Business lines of credit: A flexible way to solve short-term funding needs, for instance, inventory purchase or replacement equipment.
- Invoice factoring: Your business can turn unpaid invoices into fast cash. This is an excellent option for startups or businesses with poor credit scores.
- Business credit cards: Help cover ongoing expenses with low or no-interest credit cards. Suitable for businesses who cannot qualify for a loan.
- Merchant cash advances: Similar to a loan, a merchant advance charges interest on all funds upfront.
- SBA loans: The Small business Administration SBA offers financial help for companies who cannot seek funding elsewhere.
What are the advantages of equity financing?
The primary advantage of equity financing is that businesses are not obliged to repay the money. Of course, you have to give up a portion of your company’s ownership, but equity partners want a good return on their investment and act in the company’s best interests.
You can focus on growing your business without required payments or interest charges. You will have more capital available to invest in your company.
Disadvantages of equity financing
The primary disadvantage of equity financing is that you have to give up a percentage of your company. No matter how big or small your business, relinquishing partial ownership might be painful.
You will have to share profits and business decisions with your new partners, which could affect the company’s direction. The only way to get rid of investors is to buy them out. However, this is typically more expensive than the money they initially give you.
If you run a public business, you risk your equity investors selling your shares on the stock exchange. You may know nothing about your new partners. Privately held companies protect themselves from trading on the stock market — you must approve any transactions.
That said, there are many success stories from equity financiers. To ensure you receive the benefits of equity financing without sacrificing your vision, ensure you carefully select investors. Reach out to a broker to find an investor who will act in your business’s best interests.
What are the advantages of debt financing?
The primary advantage of debt financing is maintaining complete control over your business. Finance lenders have no claim on your business. Your relationship with the lender ends as soon as you repay the borrowed money.
In addition, you can claim tax deductions for each loan payment, saving money. Finally, it’s easy to forecast business expenses. With set monthly repayments, you can budget your debts more easily.
Disadvantages of debt financing
A business or capital loan is still a loan. You have to repay the money, regardless of business performance. What if your business hits hard times or the economy suffers? What if your company does not grow as fast as expected? Paying debt expenses (plus interest) on a regular schedule could limit growth opportunities.
Worse yet, some banks might only offer you a secured loan. While secured loans often have lower interest rates, they risk your financial assets. A secured loan uses your assets as collateral against the money borrowed. If you fail to repay your loan on time, you may lose your assets.
However, debt financing is the preferred option for businesses that desire to maintain control over their day-to-day dealings. Depending on your risk management level, debt financing might be the right choice.
Which is riskier: Debt vs. equity financing
Corporate finance is often risky, regardless of your avenue. Both options are viable but may risk your business’s future regarding debt vs. equity financing. Debt financing might be riskier if you are not profitable. Lenders may pressure you to make decisions or sell assets to pay debts you otherwise wouldn’t consider.
Yet, equity financing makes you vulnerable to investor expectations. If your new equity partners expect you to turn a healthy profit (which they usually do), they may take your business differently. Alternatively, they may try to negotiate cheaper equity or divest.
To protect your business, thoroughly consider your financing options. Which is the best choice for you? There are financing pros and cons to both equity and debt funding sources.
Why is debt financing better than equity financing?
Choosing debt corporate financing over equity is an individual decision for your business. Every company is unique. The main reason many younger businesses opt for debt financing is to avoid diluting ownership in their company. However, if you relinquish part of your ownership or lose your business, you may find equity financing a good choice.
When expanding your business, consider the debt-to-equity ratio. Too much debt could cripple your business, but too many equity partners might dilute ownership beyond recognition. Considering financial ratios is sensible.
Why is debt cheaper than equity?
Both debt and equity financing cost money. Depending on your business performance, debt costs may be cheaper than equity. However, the opposite is also true. If your business fails to profit and closes, then the cost of equity is, essentially, zero. Yet, if you take out a business loan and turn no profit, you must still repay the loan with interest.
On the other hand, if your company thrives and you turn over millions of dollars, the weighted average cost of capital could be far higher when paying shareholders than paying back a loan.
What alternative funding solutions are there?
If debt and equity financing don’t sound suitable for your business, there are a few other options.
- Working capital: You can use the money business production produces to fund your company’s growth. You may need to re-organise cash flows to free up the finances.
- Personal finance: If you have the necessary funds in a savings account, you might invest in yourself or loan the money to your business.
- Equity crowdfunding: Asking supportive members of the public to invest in your business via crowdfunding platforms is a highly popular solution. Many companies use social media to drum up support.
How to prepare for financing?
Whether you choose to fund your business with equity or debt financing, you need to prepare. Raising capital requires earning the trust of an investor or financial institution. Therefore, clear up, organise your finances, and practice your pitch to impress.
You’ll need to show investors your balance sheet and financial analytics to convince them of your business’s profitability and promising future. If you’re applying for a loan from the bank, you need to boost your credit score and negotiate interest rates.
Approaching investors for equity financing
Asking investors for money is intimidating. How do you find them? What do you say to convince them to support your business?
There are many platforms and brokers to match investors with businesses. A brokerage will support you through the transaction and ensure you make the right deal for your company.
Consider the following
Both equity and debt financing options are perfectly viable solutions. Before deciding which option is right for your business, ask these essential questions:
- How fast do you need cash? Debt financing is faster; you’ll receive the money relatively quickly, within days or weeks. You can use the funds for short or long-term needs. Moreover, loan terms are straightforward for financial planning. Equity financing takes more time to negotiate and involves time-consuming legal work.
- Do you want to maintain complete control? Debt financing enables you to maintain complete control of your company. Despite the financial burden of monthly repayments, you don’t have to give away any ownership. With equity financing, you will have to sacrifice partial control of your company. Depending on the negotiation, you could lose your majority, meaning you risk getting voted out of your company.
- Do you qualify for the type and amount of funding you need? Lenders look at your ability to repay the loan; what does your cash flow look like? Consider whether lenders will approve your application for business finance. Equity investors want to look at your business plan and future profit potential.
- How would you rather pay for financing? Debt financing requires you to repay the loan within two months, regardless of whether you’ve started seeing investment returns. With equity financing, investors receive a return when selling their shares or through dividend payments.
Is Equity or Debt Financing Right for Your Business?
The advantages vs. disadvantages of different debt and equity financing forms are endless. The right choice for you depends on your business needs and risk management. Contact a financial advisor about funding your business, and consider consulting a brokerage platform.
Frequently asked questions
Why would a business choose debt over equity financing?
Debt financing allows you to maintain control over your business. However, you will need to repay monthly payments plus interest which could hinder growth. Equity investing may cost more in the long term but is often cheaper in the short term.
What are the three forms of equity financing?
The three forms of equity financing include angel investment, venture capital, and Initial Public Offering (IPO). Each type of equity investor suits a different business model. For instance, angel investors support startups, whereas venture capitalists invest in established businesses.
Is equity financing a good idea?
Equity financing is a viable funding method to support business expansion. Investors will provide your company with the necessary funds to grow in return for partial ownership of the business. Equity financing is a good idea if you can afford to give up a small percentage of ownership.
What is an example of debt financing?
An example of debt financing might include business loans. When the bank lends money, your business can spend finances without restriction. However, you must repay the money plus interest over an agreed term.