Understanding Equity Financing vs Debt Financing: What’s the Difference

Understanding Equity Financing vs Debt Financing: What’s the Difference

Understanding Equity Financing vs Debt Financing: What’s the Difference

As a small business owner, it is your job to gain business capital. Without it, you won’t be able to grow your business. Whether you’re a startup or have been around for quite some time, there are usually two options available to you: debt financing and equity financing. Let’s dive deeper into the definition of each so you can understand how they differ and select the right one for your unique business and goals. 

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Debt vs. Equity Financing    

With debt financing, you borrow a fixed amount of money from a lender like a bank. Then, you pay it back with interest. If you go with equity financing, you’ll collect capital from an investor, rather than a lender and pay them a percentage of your business.

Equity Financing    

Equity financing is when an investor provides you with capital. Since an investor is involved rather than a lender, you won’t have to repay the funds you receive or dish out extra money for interest and fees. Instead, you’ll provide the investor with shares so they’ll have ownership stake in your business.

Types of Equity Financing

Friends and Family: If you have friends and family members that believe in your venture, they may offer you capital. Equity financing from friends and family isn’t ideal, however, because you risk ruining close relationships if your business goes south. 

Angel Investors: Angel investors are wealthy individuals or groups who choose to put money into startups and small businesses. They put a greater emphasis on growing your business than profiting from it. So, they’re more likely to share helpful advice and connect you to others in your industry. 

Venture Capital Firms: Venture capital firms invest in entrepreneurs and new, fast growing companies. Since they have strict investing rules, they are not an option for all small businesses. 

Advantages of Equity Financing  

The most noteworthy benefits of equity financing include:

No Repayment Required: If you opt for equity financing, you won’t have to repay a loan with interest and fees. With no repayment requirement, you’ll be able to hold onto your capital and can therefore reduce the risk of cash flow problems.

Valuable Business Advice: Chances are your investor has experience helping business ventures succeed. They’ll likely share their wisdom with you and help you make informed decisions. In addition, they may connect you with others in your industry and help you expand your knowledge and experience. 

Large Funding: In most cases, investors invest large amounts of money into businesses. This can be a major advantage if your business needs to hire many individuals or invest a lot of cash into a product. 

Disadvantages of Equity Financing  

While equity financing has its perks, it also comes with downfalls such as:

Ownership Loss: When you depend on investors for capital, you are no longer the sole owner of your business. Every time a new investor comes on board, your business ownership becomes more diluted and you won’t get to keep all future profits. 

Investors Have Control: Since investors have the power to make business decisions, you may face issues if you don’t agree with them. To avoid this problem, refrain from working with an investor unless you are both on the same page. 

Selective Investors: Investors, especially venture capital firms and angel investors put a lot of money into the businesses they invest in. Therefore, they are often selective and may not choose your business unless it has high growth potential. 

Debt Financing    

If you opt for debt financing, you borrow money from a lender to gain the capital you need. You’ll pay back the amount you borrow plus interest and fees by a certain time period, which is typically a few years. 

Debt financing is usually available through banks, credit unions, non-profit organizations, and alternative lenders. With this financing option, you may receive a lump sum of money or have access to a revolving form of credit.  

Types of Debt Financing

Secured Lines of Credit: A secured line of credit can allow you to draw money against a set credit limit whenever you’d like. This is a flexible financing option that’s especially useful for working capital or emergency expenses. 

Term Loans: With a term loan, you get a lump sum of money and repay it over a set time period. A term loan may be a good choice if you have to make large purchase like equipment or real estate. 

Business Credit Cards: Just like a personal credit card, a business credit makes it easy to pay for purchases. You can buy office supplies, inventory, and anything else you need up to the set credit limit. You’ll repay any funds you use plus interest. Fortunately, most business credit cards come with cash back or point rewards. 

Invoice or Receivables Financing: If you choose invoice or receivables financing, you’ll pre-sell your unpaid invoices to a lender in exchange for a lump sum payment. Essentially, this option turns your unpaid invoices into fast cash that you can use for short-term financing needs.

Merchant Cash Advance: With a merchant cash advance, you receive a lump sum payment in exchange for a percentage of future credit card sales or revenues. Compared to a term loan, a merchant cash advance typically has smaller payment amounts and shorter terms.

Advantages of Debt Financing

The most significant advantages of debt financing are:

Full Business Ownership: The lender won’t own a portion of your business so you’ll have 100% equity in it. This means you’ll get to make all the decisions and keep all the profits. 

Tax Deduction: Typically, the principal and interest you pay on a loan are considered business expenses. You can likely deduct these expenses from your business’s income and save some money on taxes.  

Short-Term Obligation: Once you repay the money you owe, you’ll have no obligation to the bank, credit union, or other entity that loaned you money. You can move forward with your business without owing them anything. 

Easily Accessible: Since there are a variety of business financing options at your disposal, you shouldn’t have an issue securing one. No matter your industry, time and business, or credit, there are likely options available to you. 

Disadvantages of Debt Financing

When it comes to the disadvantages of debt financing, the most notable ones include:

Repayments: Even if your business doesn’t succeed, you’ll be on the hook for repaying your lender. This can be nerve racking if you’re a startup who is unsure whether you’ll have the cash to make your repayments.

High Interest Rates: Unless you have stellar a personal and business credit report, you may face high interest rates that can cost you hundreds or even thousands of dollars over the life of your loan. It’s a good idea to get your free business credit scores before you apply for any type of debt financing. 

Collateral Risk: Depending on the type of debt financing you obtain, you may have to pledge assets of your business to the lender as collateral. If you default on your loan, the lender may take your collateral. 

Credit Impact: If you fail to make timely, full repayments, your credit rating may take a hit. This can make it difficult for you to borrow money with favorable rates and repayment terms in the future. 

Cash Flow Challenges: It’s unlikely that your business earns the same amount of money in each month. However, most lenders expect equal repayments every month. If your business experiences drastic cash flow fluctuations from month to month, debt financing can be risky.

Restrictions: Some lenders restrict the way you can use your funds. For example, a lender may state that you can only use their loan to purchase equipment or inventory. 

Equity Financing vs. Debt Financing: How to Choose

Now that you know the difference between equity financing and debt financing, you may be wondering which option is right for your business. Equity financing may make more sense if you have large capital needs that aren’t urgent and are okay with giving up some control of your business. It may also be a wise move if you’d like to receive valuable business advice and build industry connections in addition to capital.

Debt financing, on the other hand, may be ideal if you have smaller capital needs and do not want to give up ownership in your business. It’s also a strong pick if you feel confident that you’ll be able to make your monthly repayments and need financing quickly. If you’d like to pursue the debt financing path, check out our business loans for small businesses

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This article was originally written on January 28, 2020.

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ABOUT AUTHOR

Anna Baluch

Anna Baluch

Anna Baluch is a freelance writer from Cleveland, OH who enjoys writing about all personal finance topics. She’s particularly interested in mortgages, retirement, insurance, and investing.

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