The Difference between Debt Financing and Equity Financing: Which Is Right For You?

Getting the capital you need to run your business can be a struggle for any business owner. You need money for operations, but most importantly, you need money to grow. When you’re looking for extra funds, there are typically two options: debt financing and equity financing.

It’s important to understand the difference between debt financing and equity financing so when it comes time to get additional funding, you know which is the right fit for your business and how to get it.

Debt Financing.

Debt financing involves borrowing money from a lender outside of your business. You have to pay the money back with interest over a specified period of time. Banks, private lenders, family, and friends are all considered sources of debt financing. Lenders offering this type of funding don’t have a say in your business decisions or day-to-day operations.

Commercial Loans.

Banks offer commercial loans for businesses but they can be difficult to get for startups. They are for established businesses. You have to have a viable business plan with a good credit score and collateral to qualify. Different banks have different payment terms and rates so shop around before making a decision.

Working Capital Loans.

These are short-term loans that can help with everyday operations. You can’t use working capital loans to buy equipment or assets, but it does work really well for months with slow cash flow, especially if your business is seasonal, allowing you to pay them back when your sales improve.

Equipment Loans.

If you operate a business that uses large and expensive equipment, like a doctor’s office or auto repair shop, you may need to take advantage of equipment loans. They’re like commercial loans, but you use them to lease equipment. At the end of your lease, you can buy the equipment if you want to.

Equity Financing.

Equity financing is provided by an investor instead of a lender. This is still an entity outside of your business, but these investments don’t require you to make payments. In exchange for supplying your business with money, the investor owns a portion of your business and may have a say in your daily operations or business decisions.

The investor puts money into your business because they have faith in its success and expect their investment to grow substantially over time. They may be entitled to dividends or regular payments out of your profits as well as a large payout if you ever sell.

Private Investors.

Anyone who wants to invest in your business that is not part of a bank or alternative lender is a private investor. These investors come from many different sources like employees, suppliers, friends and family, or other local investment groups. You can find these types of investors by networking within your community.

Private investors could also be angel investors who form a small group of high net worth individuals, focused on investing in local businesses and offering services to help build your business up and see it succeed. They have a vested interest in providing assistance because they stand to make money off of your success, too.

Venture Capital.

Venture capitalists have more stringent requirements for investing, and small businesses often don’t qualify. They usually only invest in new or rapidly growing companies who pose higher risks to the investors but stand to offer a larger return.

Employees.

You may choose to sell part of your company to your employees via a stock ownership plan. This gives your employees ownership, meaning they have a vested interest in its success, but it can be expensive to maintain these plans, and you have to be in business for at least three years before you can establish an ESOP.

A Look at the Differences.

By examining the pros and cons, you can determine which may be right for you in the long run.

Debt financing pros:

• You maintain full ownership of your company without having to give voting rights to another party.
• Once the loan is paid off, you have no other obligations to the lender.
• Your loan interest is tax deductible.
• You have short-term or long-term loan options.
• You can establish a budget based on what you know the principal and interest will cost.
• Alternative lenders now provide more flexible lending options than traditional banks. For more details, click here.

Debt financing cons:

• You have a payment plan and must adhere to the time period in which the payments are due.
• These loans could cause or increase your cash flow issues instead of solving them.
• You have to offer collateral to qualify.

Equity financing pros:

• There is less risk associated with equity financing than with debt financing.
• You don’t have to pay your investors back right away.
• You can use your investor network to gain credibility or additional investment.
• Investors don’t expect payment or return on investment right away.
• You have access to more cash on hand.

Equity financing cons:

• You may pay more to your investors in the long run than you will a bank loan, depending on your level of success or how much investment you take.
• The investor owns a portion of your business and could potentially have decision-making power.

The right choice is different for every business. Established business with more proven sales and a viable business model have more financing options. While small business and new businesses struggle more, there are still options out there.

For most investors and lenders, they determine whether the risk is worth the reward. You may choose one solution that works for you or combine several options to take advantage of the benefits of each. The choice is yours.

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