Equity Financing vs. Debt Financing: Deciding Between the Two
As a small business owner, one of the many things on your plate is the financial health of your company — from managing cash flow and covering expenses to getting extra funding when it's needed. If you’re looking at financing options to help your business thrive, you might be considering equity financing vs. debt financing. While they may sound similar, they are quite different.
Keep reading to find out more about equity financing vs. debt financing and when it might make sense to choose one over the other.
Equity Financing vs. Debt Financing: What’s the Difference?
When it comes to getting funds for a small business, companies generally have two financing options: debt financing and equity financing. Let’s look further at each type as well as their pros and cons.
Debt Financing
With debt financing, you borrow money from a lender. In exchange, you promise to pay back the money at a set time, along with interest. Debt financing can be used for long-term or short-term funding purposes.
For example, you can use debt financing to purchase equipment or commercial real estate or to cover overhead expenses. Depending on the type of financing you seek, you may need collateral to secure the loan or may be required to have a credit score within a certain range.
Debt Financing Pros
Keep ownership: When you opt for debt financing, you don’t have to sell shares in the business, which allows you to maintain control. The lender doesn't gain any control over your company's operations.
Tax-deductible: In many cases, the interest paid on business loans is tax-deductible, which can lower your overall tax liability and improve cash flow.
Predictable repayment: With debt financing, you usually have a fixed repayment schedule, which can make it easier to plan and budget for repayments.
More options: There are various types of debt financing, such as lines of credit and working capital advances. This allows you to tailor your financing needs.
Debt Financing Cons
Interest payments: Debt financing involves regular interest payments, which can eat into your profits, especially during periods of high-interest rates or economic downturns.
Requires collateral: Lenders often require collateral to secure the loan, which means you could lose assets if you default on payments.
Impact on credit: Taking on significant debt could impact your business's creditworthiness, making it harder or more expensive to secure future financing.
Equity Financing
Equity financing is when you raise money by selling shares or ownership of your company. In exchange for cash, the investor may get a say in your company and a right to a portion of future profits.
While equity financing often refers to companies that are publicly listed, it’s not uncommon for startups and private companies to raise money by selling shares. In fact, it’s common for private companies to have several rounds of equity financing.
Equity Financing Pros
No repayment obligation: Unlike debt financing, equity financing doesn't require regular interest payments or direct repayment of the principal amount. This can alleviate financial strain, especially during periods of low cash flow.
Shared risk: Investors who provide equity financing share in the risks and rewards of the business. If the company performs well, investors benefit through capital appreciation and/or dividends.
Access to expertise: Some equity investors also offer mentoring, business advice, or industry connections. This guidance can help contribute to the company’s overall growth.
No collateral requirement: Equity financing typically doesn't require collateral, reducing the risk of your assets being seized.
Equity Financing Cons
Loss of ownership: Selling equity means giving up a portion of control and decision-making to the investors.
Loss of profits: Equity investors are entitled to a share of the company's profits, which means that as the business grows and becomes more profitable, a portion of those profits will go to shareholders.
Complex: Determining the value of the company and negotiating the terms of equity financing can be complex and time-consuming, requiring the involvement of lawyers, accountants, and financial advisors.
Reporting requirements: Sharing ownership with investors may require disclosing information about the company's operations, finances, and strategies.
Types of Debt Financing
There are several debt financing options available for small business owners, from both traditional and alternative lenders. There are even lenders that cater to specific types of businesses, offering a type of debt financing known as professional practice financing.
Here are some of the more common types of debt financing.
Business Loans
Business loans, sometimes called bank loans or term loans, are the most common type of debt financing. Loans can be used to buy new equipment, expand or renovate a building, or buy a new business property.
With this type of loan, you borrow money from a lender in exchange for paying it back plus interest. In some cases, you may need to include a personal guarantee or put up collateral. Your repayment terms and interest rate will often depend on the creditworthiness of your business or your personal credit score.
Working Capital Advances
A working capital advance is a type of short-term loan used to cover everyday expenses, such as supplies, vendor invoices, payroll, and other overhead costs. The point of a working capital advance is to cover a cash flow gap, either due to a seasonal or economical slowdown. Because of that, these types of loans often have shorter repayment terms.
Business Lines of Credit
Similar to business credit cards, a business line of credit is a flexible financing option. With a business line of credit, you can borrow up to a certain amount. Once the borrowed money is paid off, the credit re-opens and the funds can be borrowed again.
A business line of credit is often used by businesses that want to have a line of financing available when needed, such as to cover unexpected expenses or to not miss out on growth opportunities.
Types of Equity Financing
Equity financing is often used by startups or larger companies looking to get a significant amount of capital. Depending on where your company is in its growth, there are several methods for getting equity investing.
Angel Investors
An angel investor is someone who invests early on and often specializes in investing in early-growth-stage companies. They often will invest in companies they think have a high potential for growth over the long term. In addition to providing funds, angel investors will serve as mentors to make sure the company grows.
Venture Capitalists
Venture capitalists will often invest in companies they think will rapidly grow and often require a substantial share of a company in exchange for capital. Usually, venture capitalists get involved when the company is still small and will exit when the company lists an initial public offering (IPO).
Initial Public Offerings
An IPO is when a private company decides to go public and be listed on a stock exchange. It’s generally undertaken by large companies as it requires a lot of work and means the company is highly regulated. IPO investors tend to have less control of a company than other early investors, such as angel investors and venture capitalists.
When Should You Choose Equity Financing vs. Debt Financing?
Deciding between equity financing vs. debt financing depends on the specific needs of your company and its broader financial goals. Let’s look at when you might choose either option.
Choosing Debt Financing
You may want to consider debt financing if:
You have a good credit score: While you may be able to get a loan without good credit, you’ll likely get better terms if you have a decent credit score.
You expect a regular income to pay back the loan: Debt financing often requires regular payments on a monthly or weekly basis. You’ll need to make sure that you have enough cash flow from your business to cover your debt payments.
You want to maintain control of your company: With debt financing, you don’t need to sell any shares of ownership. This means you can maintain full control of your company while still getting the necessary funds.
You can take on the risks: Like taking out any loan, there are some risks. You may be required to have collateral or a personal guarantee. And if you don’t pay back the loan, not only will your credit score suffer, but your personal or professional assets could be taken to cover the lender’s loss.
Choosing Equity Financing
Equity financing might be a good choice if:
You can’t get a business loan: Equity financing is often an option chosen by startups without the credit and business history to get financing. Likewise, if you’re struggling to get approved for a business loan, equity financing might be one of the few options available.
You want a business mentor or partnerships: Equity investors often not only invest in the company but also provide mentorship and guidance. If you’re looking for extra advice and want a business mentor, then equity funding might make sense.
You want to avoid debt: If you don’t want to go into debt or have to make interest payments, then equity financing might be worth considering. Debt financing requires regular payments, which could hurt your business's ability to grow over the short term.
You don’t mind sharing ownership of your business: When investors purchase shares of a company, they expect to be involved in the decision-making. If they own more than 50%, you could lose control of your company and have to buy out investors to get it back, which can be costly.
Finding the Right Financing for Your Small Business
When it comes to choosing equity financing vs. debt financing, it depends on your current business needs and goals. When looking for short-term financing to cover a cash flow gap, for example, debt financing might make sense. But if you’re looking to grow your company, want a business advisor, and don’t mind giving up shares of your company, then it might make sense to look into equity financing.
If you're looking for debt financing, Backd is here to help. Backd’s working capital advance makes it easy to access up to $2 million, while their business line of credit offers revolving credit of up to $750,000 with competitive terms.
Apply now and receive an approval decision in 24 hours.
