Debt Financing vs Equity Financing: What Are the Differences?

debt financing vs equity financing
62
VIEWS

When it comes to funding your business, you want to make sure you make the right decision for your business based on your current needs. If you need the money to expand, you may wonder, what funding option is best for me? In general, you can obtain two major types of business funding: debt financing vs. equity financing.

So what is the difference between debt financing vs. equity financing? Continue reading below to find out! In this brief business funding guide, we will cover what you need to know about these two major types of financing and how you can decide which one of the two are best for you and your business needs.

What Is Debt Financing?

Debt financing is similar to how loans work, in the essence that you are borrowing money with the intention to pay it back. Debt financing your business means that you accept funds from an outside source and promise to repay the debt with interest. This is an excellent option for those looking to secure government contract financing.

You will make monthly payments towards the principal and interest in addition to putting up collateral to reassure the lender that you will make good on your promise. You can put up your insurance policy or real estate as collateral if you would like.

Other forms of collateral you can use:

  • Equipment
  • Inventory
  • Accounts receivable

In the event that you default on your loan, the lender will take possession of your collateral. They will then sell the collateral to recoup what the lender provided to you.

Different Types of Debt Financing

There are several different types of debt financing, a few of which you may already be familiar with. For example, traditional bank loans are a form of debt financing. If you can obtain a conventional bank loan and have good credit, you may receive favorable terms.

Merchant Cash Advances

Merchant cash advances are loans from an alternative type of lender. In this instance, you repay the lender with a portion of your debit and credit card sales. If you decide to pursue a merchant cash advance, it is essential to note that they typically come with high APRs.

SBA Loans

SBA Loans are loans backed by the Small Business Administration. To receive an SBA loan, you must apply through one of the SBAs partnered banks.

These types of loans are popular amongst business owners, and if you qualify, you could receive a loan with low-interest rates and longer terms. Although these loans are popular, they are harder to qualify for due to their strict requirements.

When To Consider Debt Financing

It is best to consider debt financing if you are able to qualify and expect a positive return. For example, if you plan on taking out $300,000 with a 9% APR but you project that you will receive a rate of return of 20%, it may be worth the risk. Repaying the debt can work in your favor, not just because of your rate of return, but because paying back this debt also helps build your business credit.

What Is Equity Financing?

Equity financing is when you sell a stake in your company to investors who wish to share in the future profits of your business. You pitch your idea to some investors, and they decide to either invest or not. Typically, if they agree to invest in your company, they will provide you with terms you must agree to before releasing your funds.

Instead of repaying the investor monthly, you pay the investor through company profits because they will be partial owners of your business. This also means that they may have a voting stake in your company, depending on the terms of your agreement.

Common Types of Equity Financing

A common type of equity financing is angel investing. These types of investors are wealthy individuals who have the capability of providing your business with a large amount of cash. In return, they typically ask for a share in your company.

Equity Crowdfunding

Equity crowdfunding is when you sell small shares of your company to various different investors via a crowdfunding platform. Once you find a platform you like, you will have to market your business to hit your goal and get the funding you need.

Venture Capitalists

Venture capitalists are entities or individuals who invest their money into companies; typically, they invest in high-risk startups. In certain instances, the growth potential of the startup business offsets the investor’s risk. In return, the venture capitalist typically looks to either purchase the company outright or have a substantial amount of shares in the company.

When To Consider Equity Financing

Consider equity financing if you are a startup company or your business is not yet profitable and needs funds. Most startups aren’t able to acquire the money they need to hit the ground running, so they may turn to venture capitalists or angel investors to help them get started.

You Wish To Avoid Debt

Equity financing may be less risky than taking out a large loan to finance your business. If you want to grow your business and don’t have the cash flow, you may be better off looking into equity financing options. This way, you won’t have to worry about making regular payments that could affect your cash flow.

You Want To Find a Mentor or a Partner

Investors not only offer you capital to grow your business, but they also offer advice. Their industry expertise and knowledge are just as valuable as the money they lend your company. If they take an active role in your business, they can help it grow.

Debt Financing vs. Equity Financing

So between debt financing vs. equity financing, what is the best option for you? That question is essentially up to you and your business needs.

If you are a startup looking for capital to grow and want someone with experience and knowledge to help you forge a path, lean more towards equity financing. For those who are ok with taking risks and are comfortable with making monthly payments and putting up collateral, debt financing may be the answer for you.

Advantages of Debt Financing

All financing options have advantages and disadvantages, so it is best to know about them before you make your final decision. One of the most significant advantages of utilizing debt financing is knowing exactly how much you own and how long you have to repay the borrowed money.

Tax-deductible

When tax time comes around, you have the opportunity to deduct your interest payments from your taxable income. This can help save you a lot of money by reducing your tax liability.

Disadvantages of Debt Financing

Although there are several advantages that come with debt financing, you should keep a few disadvantages in mind. For example, a disadvantage of debt financing is the repayment terms.

Depending on your lender, you may have to start making your payments one month after you receive your loan funds. This can be challenging if your business doesn’t have firm financial footing yet.

Interest Rates

Depending on your business credit score, you may not have favorable interest rate terms. Even if you need the money to start your business, it is best not to take the loan if you are unsure if you can pay back the principal and the interest rate.

Advantages of Equity Financing

Equity financing is excellent for startup businesses that are in high-growth industries. When seeking funding from venture capitalists, they look for companies primed for rapid growth. If this sounds like your business, you will have a better time securing the funds you need from equity financing.

No Repayment Until Later

Until you can scale your business and become profitable, you won’t have to make any payments. Your investors are prepared to wait until your business makes a profit before recouping their investment.

If your business were to fail, there is no need to repay the investors. On the other hand, if you took out a loan and your business failed, you would still have to repay the debt.

Disadvantages of Equity Financing

Equity financing is an excellent vehicle to finance your business ventures, only if you can secure financing from investors. Unlike debt financing, equity financing is a bit more challenging to obtain. You must have a robust personal network or the ability to market your business to reach the capital you need.

Investor Involvement

For some, investor involvement is a dream come true. For others, it can be a complete nightmare, depending on who they partner with. Depending on the terms of the agreement, investors may have voting control or a large share of the company, which can be an issue if you want complete control of your business.

Secure the Funding Your Business Deserves!

Now that you know the difference between debt financing vs. equity financing, it’s time to secure the funding your business needs! Each option has its pros and cons, and it is ultimately up to you to decide which option is best for your current business needs. If you found this article helpful and want to learn more about financing options, check out our Finance section!