Choosing which type of funding is best for your business can be challenging – especially with how many options are available today. However, it’s important to remember that no company is the same, meaning your decision is based on your unique needs and company structure. It’s helpful to categorize the various funding options into two sections: debt financing and equity financing. From there, you must consider your specific financial needs, the current economic climate, and a variety of other factors. Let’s start simple, though, and help you understand the difference between debt and equity financing.
What Is Debt Financing?
At some point, you’ve probably heard of a loan. Loans can be helpful for various scenarios, from college tuition and a mortgage to a new vehicle or business building. Debt financing occurs when a borrower (you) accepts funds from an outside source (lender). Over time, you are responsible for repaying the principal plus interest, which is the “cost” of the money initially borrowed. You will set up monthly payments with the lender that go toward the interest and principal. The lender will likely have you put up some assets for collateral which will be used for repayment if you default on the loan. A range of items qualify as collateral, like insurance policies, equipment, real estate, and more. Debt financing is available in many forms depending on the type of organization, such as:
- Lines of credit: Banks and other financial institutions offer lines of credit. Lines of credit have low-interest rates, and you can draw from the lump sum of money whenever needed. You’re also paying interest on only the amount of money used.
- Traditional loans: Banks and alternative lenders offer traditional loans. However, if you don’t meet application requirements, it can be challenging to get approved. It’s recommended to pursue a loan from a bank rather than from an alternative lender because interest rates tend to be more favorable.
- Business credit cards: You’ve likely had a personal credit card at one point or another, and business credit cards work similarly. Depending on the business credit card you choose, you may have access to features and rewards that benefit your company.
- SBA loans: You will likely be eligible for an SBA loan from the federal Small Business Administration as a small business owner. You’ll have access to a variety of low-interest, long-term loans through SBA-approved banking partners.
- Invoice or receivables financing: You can turn to financial companies if you need cash on hand fast. Through invoice or receivables financing, capital will be fronted at a discount in exchange for income that you’ll receive later on.
- Merchant cash advances: While merchant cash advances tend to have high annual percentage rates (APRs), it’s a great debt financing option if you receive a majority of your revenue through credit card sales. Over time, the lender for your merchant cash advance will repay your loan by pulling a portion from your company’s credit card sales.
Using Debt Financing for Your Business
Debt financing can be beneficial for your business for various reasons, but you must consider all avenues when choosing between debt and equity financing. Getting a business loan can be challenging – especially if your company is getting off the ground. However, if you can qualify and meet the application requirements, you could get a competitive interest rate.
Debt financing is an excellent way to maximize your money and build your business credit. If your business credit is exceptional, you’ll have a higher chance of getting better rates and returns down the road. Debt financing easily gives you more long-term financial benefits when compared to equity financing. Additionally, you must account for collateral being at risk if you fail to repay the debt. Aside from these factors, there are also clear pros and cons to debt financing:
|Pros +||Cons –|
|Clear and finite terms||Repayment requirements and interest fees|
|Lenders aren’t involved in company operations||Repayments start immediately|
|Interest payments are tax-deductible||Risk of personal financial loss|
|Almost any kind of business can use debt financing – no matter the size||Lenders can place restrictions on how and where money is used|
|Variety of options||Revenue reinvestment limitations because of expenses|
|Debt interest can be deducted on tax return||High risk at all times|
|Low interest rate loans||Principal and interest must be repaid – no matter the state of your company|
What Is Equity Financing?
At times, you can sell a stake in your company to investors interested in sharing your business’s future profits. If you’re familiar with this form of financing, you already know what equity financing is. Equity financing can be obtained by dealing with a venture capitalist or equity crowdfunding that we’ll explain below. Unlike debt financing, you won’t be required to make monthly payments or be affected by high-interest rates with equity financing. Instead, interested investors will be involved in a portion of company operations since these figures are considered partial owners of your business. Equity financing can be obtained in many ways, such as:
- Angel investors: At times, private associations or wealthy individuals (angel investors) will invest a significant portion in your company in exchange for a large ownership percentage.
- Venture capitalists: Large firms invest substantial amounts of money in your company and make their contribution known to the public. Venture capitalist investments occur if these entities view your startup as promising. However, it’s not unusual for an entity to become interested in buying a portion of shares or purchasing your company entirely over time.
- Family and friends: Encouraging your friends or family to put a small amount of money into your business can be beneficial in exchange for a small portion. However, this can be risky, especially if you end up losing their contribution.
- Equity crowdfunding: You will sell small shares of your company to multiple investors through crowdfunding platforms. However, to reach your goal and get funding, you’ll have to develop an effective marketing strategy, and it can be time-consuming.
Using Equity Financing for Your Business
Equity financing can also be beneficial for your business for a variety of reasons. However, like debt financing, you must consider all avenues. If your company is a startup or hasn’t yet started gaining profit, it can be challenging to get a business loan, and you likely want to avoid racking up unnecessary debt. Equity financing is an excellent option if you want to avoid debt altogether because you aren’t required to repay a loan or put collateral at risk.
If you choose to move forward with equity financing, it’s helpful to find a partner or mentor that can share both knowledge and experience. Investors can offer working capital to help build your company, and they’re often willing to take an active role in your business’s growth and success. However, by working with an investor, you must be prepared and comfortable giving up some control. An investor will own a portion of your company, meaning you could lose complete control of your company, and it can be costly to regain it. Aside from these factors, there are also clear pros and cons to equity financing:
|Pros +||Cons –|
|Great for startups in fast moving industries||Difficult to obtain|
|Rapid scaling||Potential loss of business ownership percentage|
|Repayment isn’t required till your business is profitable||Investors are involved in company operations|
|All risk is on investors and returns are received only in the event of business success||Returns on investments aren’t expected by investors for 3-5 years, however many exit after 5-7 years|
|Revenue is never diverted to loan repayment|
Choosing Between Debt and Equity Financing
It can be challenging to choose between debt and equity financing – especially if you aren’t aware of the pros and cons. While making your decision, it’s recommended to consider your business type and measure advantages compared to overall risk. It can also be beneficial to study competitors and industry trends as this will give you an idea of what might or might not work. Make sure not to jump on the first debt or equity financing option either. Take time to explore different financial products so that you can make the best decision for your unique needs and business structure.
Whether you’re a new business owner or your company is established but you need funding, choosing between debt and equity financing can be challenging. There are many options available to business owners today, each with its own advantages and disadvantages. You must take your company’s unique needs and overall structure into consideration when making your decision. If you’re unsure of what way you should go, it’s suggested to seek guidance from a business financial advisor so you choose the best funding option for your company.