Pros And Cons Of Debt VS Equity Financing
No matter what type of small business you operate or how long you’ve been in business, there comes a point when all business owners need extra capital. From paying startup costs before you open your doors to growing your business and boosting your profits with an expansion, you need capital.
Most small business owners don’t have pockets deep enough to cover all expenses themselves. Instead, these entrepreneurs seek financing from outside parties to fund their startup, pay for expansion, or even cover day-to-day operating costs when money is tight.
If you’re a small business owner who needs extra capital, there are two main types of financing to consider: debt financing and equity financing. Both types of financing provide funding for your small business, but which is right for you?
In this post, we’ll break down the differences between debt financing and equity financing. We’ll look at how each type of financing works, discuss the benefits and drawbacks, and talk about which is the best choice for your business. By understanding how debt and equity financing differ, you’ll be able to make the most informed financial decision for your business.
Let’s get started.
Table of Contents
What Is Debt Financing?
Debt financing is pretty much what most people think about when they hear the word “financing.” With debt financing, a lender provides you with the capital you need for your business. Over time, you’ll repay the lender the money you’ve borrowed, plus interest.
How Debt Financing Works
How does debt financing work? It’s quite simple to understand, actually. As we mentioned above, debt financing occurs when a lender charges interest and/or fees to give you the capital you need. The money you borrow, plus these additional charges, are paid back over a set period of time, which could be weeks or even years.
But now let’s take a more detailed look at debt financing. You’ll apply to receive money from a lender. This could be your bank, credit union, a non-profit organization, an alternative lender, or other individual or company that provides your business with capital. You may receive a lump sum, or you may have a more flexible revolving form of credit, which we’ll cover in more detail a little later.
Your lender will consider a few factors to determine if you qualify for financing. These factors vary by lender but could include:
- Personal Credit Report & Score
- Business Credit Report & Score
- Annual Revenue
- Time In Business
Your lender may use a combination of these factors and/or additional factors to figure out whether you qualify for financing at all, and if so, determine your total borrowing amount and the rates and terms of the loan.
Over time, you will pay back the amount of money borrowed, in addition to any fees or interest charged as agreed upon between you and the lender. Once you have paid back the principal (your borrowing amount) plus the lender’s fees and interest, there are no additional steps to take. You can certainly apply for additional financing, but you are not obligated to do so.
One thing to be aware of is that some types of debt financing are secured with collateral. For most lenders, business assets are acceptable forms of collateral, although personal property and assets may also be used. If you default on your agreement — that is, you do not pay back the borrowed amount plus interest and/or fees within the agreed-upon time frame — the lender has the right to seize this collateral to pay off the debt.
However, even if you’ve put up collateral for a loan, the lender does not hold a stake in your business. This is what sets debt financing apart from equity financing, which we’ll cover a little later.
Types Of Debt Financing
There are multiple types of debt financing to consider if you opt to go this route. The type of financing you select will depend on your specific circumstances. Let’s take a look at a few of the most common types of debt financing.
Loans are what most people think of when discussing debt financing. A loan is a lump sum of money given to you that is repaid over a set period of time. A long-term loan is paid back over several years; this is the type of traditional funding you would receive from your bank or through a Small Business Administration program. These loans are best for larger business purchases, such as equipment or commercial real estate and are typically only available to those with good credit and established businesses.
Short-term loans offer quick cash to borrowers with less ideal credit and time in business qualifications and (as the name would suggest) are repaid over a shorter period of time. These products are best for smaller purchases, such as supplies and inventory, or to cover an emergency expense.
Lines Of Credit
Lines of credit offer a more flexible financing option. With a revolving line of credit, you’ll be able to make multiple draws against a credit limit set by your lender. As you repay your principal, interest, and fees, funds will become available to use again. You can withdraw up to and including the credit limit through one or multiple draws. Once you initiate a draw on your line of credit, the funds are sent to your bank account, where you can access them in as little as one business day. Lines of credit are particularly useful for emergency expenses or working capital.
Business Credit Cards
A business credit card works just like a personal credit card. Your lender sets a credit limit, and you can make purchases with the swipe of a card anywhere credit cards are accepted. You’ll repay any funds used, in addition to any interest charged by the lender. Interest is applied only to the borrowed portion of funds. Business credit cards can be used to purchase supplies or inventory, pay for unexpected expenses, or to set up recurring payments (utility bills, etc.).
Accounts Receivables Financing & Invoice Factoring
Accounts receivables financing — or invoice financing — uses your unpaid accounts receivables as collateral for a line of credit. Invoice factoring is also an option. This is when you receive a lump sum of money up front for your unpaid invoices. Once the invoices are paid, you receive the remaining amount owed to you, minus any fees charged by the lender. Both are good options to improve cash flow that has slowed due to unpaid invoices.
Debt Financing Pros & Cons
Debt financing certainly has its benefits, but there are drawbacks you must consider as well. Let’s take a closer look at the pros and cons of this type of financing:
- You Retain Business Ownership: With debt financing, your ownership interest is not diluted. This means that you won’t have to share your profits over the long term.
- Multiple Options Available: From flexible lines of credit to long-term loans that give you a lump sum of cash, you can find debt financing for any situation.
- Planning Ahead: With debt refinancing, you know exactly when to pay, how long you’ll be paying, and the amount of each payment.
- Tax Benefits: Interest for your financing can be used as a deduction on your income tax return.
- Availability: Debt financing options are available to almost all businesses, regardless of factors such as size, industry, time in business, or business or personal credit history.
- Interest & Fees: Even borrowers with the highest credit scores and most profitable business have to pay interest and/or fees for borrowing. Borrowers that are seen as “risky” by lenders face even higher costs.
- Taking On Debt: True to its name, debt financing means you are taking on debt. This raises your DTI ratio, making your business look like a bigger risk to investors and lenders.
- Risk Of Default: Even the well-intentioned borrower can fall upon hard times and miss a payment. Months of hardships can lead to default, which puts your collateral and credit score at risk.
- Difficult Borrowing Requirements: Even though there are many debt financing options, you may not qualify for the product you need. For example, if you have a low credit score, short time in business, or low annual revenues, you may only qualify for smaller short-term loans or lines of credit. This could pose a problem if you’re looking to borrow a larger sum of money for a longer period of time.
- Potential Restrictions: Some lenders impose restrictions on how funds are used. If you want more flexibility than what one lender is offering, you have to find another lender … or consider equity financing.
What Is Equity Financing?
With equity financing, you can also receive the capital you need for your business. However, instead of borrowing money that you repay with interest, an investor provides the capital in exchange for ownership interest in your business.
How Equity Financing Works
Equity financing is significantly different from debt financing. Instead of seeking a lender, you’ll look for an outside investor. That outside investor will provide you with capital in exchange for shares in your company. The investor then has an ownership stake in your company.
You will not have to make regularly scheduled payments to your investor as you would with a lender. Instead, the investor will take a share of your profits as your business becomes successful. The investor will also have some control within your company, including the power to make decisions.
Let’s look at an example of how equity financing works:
You invest $700,000 in your new business. An investor is willing to invest $300,000. You agree to a price of $1 per share. Your business now has $1 million in capital. You control 70% of the shares, but the investor has purchased 30% of your business.
Types Of Equity Financing
Does equity financing seem like a smart financial move for your business? Before you get started, there are several different types of equity financing to consider.
Venture capitalists (VCs) are willing to invest millions of dollars in companies that have the potential for high returns. Therefore, most small businesses would not be of interest to VCs. However, promising tech and innovation startups could benefit from the equity financing offered by VCs. VCs use money that is pooled from sources, including investment companies, corporations, or pensions. It is rare for a VC to use their own money for investment.
Angel investors, like VCs, are willing to invest money in promising businesses and startups. However, angel investors are a little different because these are accredited investors who use their own money for investments. An angel investor may be someone you don’t know, or it could even be a friend, family member, or colleague who has a high net worth and annual income.
Mezzanine financing combines traits of both debt and equity financing. Your business takes a loan and agrees to repayment terms. If you are profitable, you retain ownership of your business. If your business is not successful, the lender is able to convert the loan into equity interest, giving claim to future profits.
The internet has made it easier than ever for small businesses to raise capital. With crowdfunding, you can make your pitch to the public to raise capital for your business through an online platform. While some businesses promise rewards in exchange for investments, such as a new product for free or at a reduced price, others use equity to bring in investors. Learn more about the best equity crowdfunding sites.
Equity Financing Pros & Cons
Similar to debt financing, equity financing has benefits and drawbacks to consider. Take a look at these pros and cons to determine if equity financing would be the smartest financial move for your business.
- Investors Take On Risk: With equity financing, the risk falls primarily on the investor. Investors only see their returns if your business is a success.
- Good For New Businesses: If you’re a brand new business with no revenue, equity financing could be the best option for you. While you may qualify for debt financing, you’ll likely be stuck with low borrowing limits and less-than-desirable rates and terms.
- No Interest Or Fees: With equity financing, you won’t have to worry about paying interest and/or fees on a loan or other financial product. This gives you more money to invest in your business.
- Investors Bring More To The Table: The right investor brings more than just capital to the table. You can gain industry knowledge, meet new connections, and gain experience that you wouldn’t receive by working with a lender.
- Giving Away Ownership: With this type of financing, you’re giving away ownership in your business. Not only does this reduce your share of profits, but it also gives outside parties the power to make decisions surrounding the operations of your business.
- Finding Investors Is Difficult: Finding one or more people willing to invest in your business can be a difficult and time-consuming process. If you need money quickly or with little effort, equity financing is likely not the right option for you.
Debt VS Equity Financing
As you can see, there are very clear differences between debt and equity financing. With debt financing, you simply have to meet the criteria of a lender in order to receive money. Depending on the type of financing you seek, you could have the capital you need in as little as 24 hours. In exchange for this capital, you pay the lender back as agreed. You take on all the risk, so if your business fails, you may lose your assets or face legal action.
Additionally, with debt financing, you don’t have to worry about drawing up legal paperwork. Apply for your loan, submit the required information and documentation, and the lender will provide you with money if you qualify. You retain full ownership of your business.
On the flip side, equity financing could take some time. It is up to you to find the right investors willing to work with your business. Drawing up legal paperwork will be part of the process as well.
While you don’t have to pay your investor back over the short-term, the lender will recoup their money if your business is successful. Because they will own part of the company, they will be able to take their share of the profits and make important decisions about your business along the way.
The risk is on the lender. If your business is successful, the lender gets their capital plus a return. If your business is unsuccessful, you will not be indebted as you would with debt financing.
Which Type Of Financing Is Best For Your Business?
The type of financing you select depends upon the specific financial needs of your business. If you’re still on the fence, consider why you need capital, how you envision your business in the future, and these additional factors to determine whether to choose debt financing or equity financing:
Choose Equity Financing If…
- You picture your business growing to a global or national scale
- You have larger capital needs that wouldn’t be satisfied through debt financing
- You’re willing to give up some control over your business in exchange for equity
- You’re looking for more than just money, i.e. industry connections and experience
- You’re willing to put in the work to pitch to investors
- Your capital needs aren’t urgent
Choose Debt Financing If…
- You have smaller capital needs
- You need capital but don’t want to give up ownership interest in your business
- You’re willing to take on risk, including losing assets if you fail to repay your lender
- You need financing quickly
If debt financing seems like the right option for you, give Lendio a try.
Lendio is a loan aggregator that has over 75 financing partners ready to serve small businesses just like yours. Through Lendio, you can reach these lenders and receive multiple offers with just one application.
No matter what your financial needs, Lendio has a financial product for you. Through Lendio, you can apply for Small Business Administration loans, short-term loans, equipment financing, commercial mortgages, startup loans, and more. Total borrowing limits, interest rates, and repayment terms vary by lender and financial product.
There are many ways to get capital for your business through debt financing or equity financing. However, it’s very important that you weigh out the pros and cons and consider the specific needs of your business before moving forward. While your capital needs may be urgent, it’s critical to look at the long-term picture to determine what type of financing will most benefit your business.