Equity Financing vs. Debt Financing: Which is a Better for Your Business?
Ezra Cabrera | February 18, 2022
Key Takeaways
- Equity financing and debt financing are two financing options businesses can choose from when looking to raise capital for their business.
- Equity financing involves the selling of equity to investors, who then gets a share of the company and becomes part-owner. Debt financing, on the other hand, involves borrowing money from financing institutions such as commercial banks, credit unions, and FinTech companies and repaying the borrowed cash over an agreed-upon period.
Businesses usually have two options when it comes to funding their business: equity financing and debt financing. Both types of funding options allow business owners to raise enough capital to address business needs such as sustaining day-to-day operations or investing in business growth opportunities.
But with both having the same purpose, how do you choose which one to pick for your business? In this article, we’ll explore the differences between the two options and help you decide which way you should go for your business.
What is Equity Financing?
Equity financing is a funding option wherein the company sells its equity in the form of common stock to willing investors. The investors could come from crowdfunding platforms, or they could be wealthy individuals or a company composed of a group of wealthy individuals (venture capitalists). Each unit of stock the investors buy is equivalent to a unit of ownership in the company.
That means, if you sell 30% of your equity, your investors will own 30% of the company, leaving you with 70% in your ownership. Since the investors own a significant part of the company, they will be entitled to a portion of the profits.
Moreover, some investors may require a seat on your Board of Directors and take part in the company’s major decision-making processes moving forward. This is true, especially if you’re working with angel investors or venture capitalists whose primary goal is investing in small, promising businesses.
Pros and Cons of Equity Financing
Before going forward with your plan to fund your company through equity financing, it’s important to consider the pros and cons first. Here are a few things you need to know.
Pros
- You don’t have to pay the principal and interest. Conventional business loans typically have high-interest rates, especially if they’re working with a subprime borrower. With equity financing, on the other hand, you won’t have to pay interest or pay back the capital you raised. You’ll be exchanging equity for funding, and in turn, the investors will get a dividend on whatever profit you earn in the future. That said, you won’t have to set aside a budget for debt repayment each month.
- No need for collateral. Other than equity, you won’t need to put up collateral to secure the funding. This makes it a perfect option for startups with insufficient assets to qualify for any business financing option.
- Chance to work with experienced business owners/investors. Angel investors and venture capitalists are often retired or experienced business owners seeking to invest in businesses where they have expertise. That said, as an equity holder for your company, they can actively participate in the management and act as a mentor to help you grow your business further.
- Possibly larger funding amounts than debt financing. Equity investors, specifically venture capitalist firms, are more likely to invest larger amounts in a business, especially if they think it has a high potential for success. Plus, with equity financing, your credit score won’t be a significant consideration for the funding. That said, even if you have poor credit standing, you’ll still be able to get a higher funding amount. This can be helpful for startups that need a substantial amount of capital to fund specific business initiatives like hiring employees or buying expensive equipment.
Cons
- You give up some control over your business. As mentioned, with equity financing, you’ll be selling equity or company stock in exchange for capital. That means you’ll have to give up partial ownership of the business and sometimes control, depending on the agreement. The investors who bought equity in your business can participate in the business activities.
- Hard to acquire. Investors are constantly looking for the next big thing. They want to invest in a business that they know has a high potential for success and will generate substantial returns in the future. So, companies that can demonstrate high-growth potential, like technology-based businesses, may have better chances of attracting wealthy investors.
That means, if you sell 30% of your equity, your investors will own 30% of the company, leaving you with 70% in your ownership. Since the investors own a significant part of the company, they will be entitled to a portion of the profits.
Moreover, some investors may require a seat on your Board of Directors and take part in the company’s major decision-making processes moving forward. This is true, especially if you’re working with angel investors or venture capitalists whose primary goal is investing in small, promising businesses.
That is not to say that all investors are like this. You can still find an investor for your company even if you’re not technology-based. However, you may have to do extra legwork to find an investor that works with businesses specific to your industry.
What is Debt Financing?
Debt financing comes in the form of business loans. They could come from banks, credit unions, alternative lenders, friends, or family members. Business lines of credit, equipment financing, and SBA loans are a few examples of debt financing.
The main idea of debt financing is borrowing funds or capital with the intent to repay it with interest over a specific time frame. Once you’ve paid the loan amount back in full, plus the interest, the lender-borrower relationship between you and the financing entity will end.
With debt financing, the lenders may require the business owners to pledge collateral to secure the loan. This is true, especially if they’re working with high-risk businesses or subprime borrowers. The collateral could be in the form of commercial real estate or high-valued equipment.
The major downside of debt financing is that you’ll risk losing a valuable asset if you fail to make the required repayments. If you default on the loan, the lenders can seize your asset, liquidate it, and use the proceeds to pay for the loan balance. Furthermore, your credit score will take a hit, hurting your chances of qualifying for traditional loans in the future.
3 Steps to Calculating Your Overhead Rate
Your overhead rate is one of the most significant metrics in your business. It measures or calculates the portion of your sales that will need to be put towards paying your overhead. It also determines the costs that are not directly tied up to the production of goods or the delivery of your services, helping you come up with a better price for your products or services.
Here are the three steps you can follow to calculate overhead costs:
Pros and Cons of Debt Financing
Again, just like other types of funding options, it’s important to examine the benefits and downsides of debt financing before moving forward with the application. We’ve laid out the pros and cons of debt financing below.
Pros
- Faster funding. Applying for small business loans from lenders could be a quicker way to obtain the funds you need to address time-sensitive opportunities or unforeseen situations. Online lenders, specifically, only require you to submit a form online along with some documents (bank statements, driver’s license, etc.). Once you submit the form, their system will get to work and evaluate your eligibility. In some cases, businesses can get approved within 24 hours to a few days after applying.
- Retain complete control over your business. Since you’re not selling equity in debt financing, you won’t have to give up control over your business. The investors won’t be entitled to your future profits, and they can’t participate in any business activities and decision-making processes. Once you’ve paid the loan off in full, the lending contract will be terminated, and you can continue running your business as usual.
- Tax benefits. In case you didn’t know, the interest rate you pay for your small business loan is tax-deductible as the interest rate is considered a business expense. However, to be eligible for the tax write-off, you’ll have to meet specific criteria, like you and the lender must have a true lender-debtor relationship. This means that the loan shouldn’t come from friends or family members.
Cons
- You’re obligated to repay the borrowed amount, plus interest. It’s safe to say that with debt financing, you’ll have to pay the money back to the lender, plus interest. If your business is experiencing cash flow issues, this may be harder to fulfill, and you could end up with missed payments. In turn, your credit score will take a hit, making it even harder to qualify for a more comprehensive financing option in the future.
- It’s tougher to qualify for excellent financing terms. With debt financing, banks and other lending institutions will consider your credit score when evaluating your eligibility. Essentially, the better your credit score is, the higher your chances are of securing financing with excellent terms (low-interest rate, longer repayment periods, higher funding amounts, etc.). However, if you lack enough credit history and your credit rating is less than stellar, your chances of getting excellent financing terms significantly decrease. As a result, you might end up with a small business loan with a high-interest rate.
- You’ll need collateral. Many lenders will require collateral to secure the funding. This is true, especially if you’re applying for SBA loans, term loans, or if you’re applying with a low credit score. If you default on the loans, the lender has the right to seize the asset and use it as payment for the loan. With debt financing, you could risk losing a valuable asset for good.
| Differences | Equity Financing | Debt Financing |
|---|---|---|
| Meaning | Raising funds by selling company shares or equity, thereby giving the investors ownership rights to the company. | Business owners borrow funds from lenders, which they have to repay with an interest rate within a specific period. Debt financing doesn’t give ownership rights to the lenders. |
| Duration | Comparatively short-term financing than equity financing. Once the business pays the loan back in full, the business’ relationship with the financing company ends. | Comparatively short-term financing than equity financing. Once the business pays the loan back in full, the business’ relationship with the financing company ends. |
| Investment Payoff | Equity financing doesn’t require repayments for the funds. However, the shareholders get a dividend on the profit earned by the company. | Equity financing doesn’t require repayments for the funds. However, the shareholders get a dividend on the profit earned by the company. |
| Funding amount | Regardless of the credit score, investors typically shell out higher amounts of funding for a business they think has a high chance of succeeding. | The funding amount will depend on the credit score and financial health of the borrowing business. |
| The funding amount will depend on the credit score and financial health of the borrowing business. | No collateral requirement as the investor holds a share of the company. | No collateral requirement as the investor holds a share of the company. |
| Collateral requirement | No collateral requirement as the investor holds a share of the company. | Collateral may be required to secure the funding and mitigate the risk the lenders face. |
How to Choose Between Debt Financing and Equity Financing
Equity and debt financing can give your business the much-needed capital to sustain your business operations or take advantage of business opportunities. But how do you choose which one is right for your business?
In general, equity financing would make more sense if:
- Your business demonstrates high growth and a high potential for success.
- You need a larger funding amount to invest in business growth opportunities.
- You’re okay with giving up some control over your business.
- You have no problem working with investors in managing your business.
- You want to work with investors with extensive knowledge and experience in your industry.
On the other hand, debt financing would be a better option under the following circumstances:
- You want to retain complete control of your business.
- You don’t want to risk working with investors you don’t see eye to eye with.
- You’re okay with repaying the borrowed capital plus interest.
- You’re in a hurry to get the funding, and you don’t have the time to throw a pitch to possible investors.
- You have excellent credit scores and financial history.
- You have collateral to pledge
Equity Financing vs. Debt Financing: Final Thoughts
Ultimately, the equity financing vs. debt financing debate can only be resolved by knowing where your business currently stands and what its needs are. If you’re a startup that can’t qualify for a loan from traditional banks but has high-growth potential, equity financing might be a better choice. However, if you’re not comfortable working with shareholders in the decision-making processes of the company and have excellent credit standing, debt financing would make more sense.
Both financing options have their advantages and drawbacks. Weigh them carefully before deciding which one you should choose for your business.
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