The Difference Between Debt and Equity Financing
Here’s how to determine if you should accept debt or share ownership of your business.
- Your firm can be financed in a variety of ways, including debt and equity.
- Debt is the direct borrowing of money, whereas equity is the sale of stock in your firm in an effort to raise money.
- Both have advantages and disadvantages; thus, many firms opt to combine the two funding options.
- Small company owners who are attempting to determine whether debt or equity financing is best for them should read this article.
Chances are good that you’ll need some type of capital in order to start a firm unless you already have an established empire of money on which to expand. Small company owners have a variety of financing alternatives, including bank loans, alternative loan types, factoring services, crowdsourcing, and venture capital.
It might be challenging to choose the best solution for you and your company from this variety. The first thing to understand is that firms can obtain finance in one of two major categories: debt or equity. It might be challenging to choose the best course of action for your company because each choice offers advantages and disadvantages. [Read our selections for the best small business loans.]
An explanation of debt and equity finance, what they represent, and crucial information to consider are provided below. [Read our guide to learn more about additional nontraditional financing options for entrepreneurs.]
What is debt financing?
Whether we’ve taken out loans for a house or education expenses, many of us are familiar with the concept of loans. It’s similar to funding a firm using debt. The borrower takes funds from a third party and makes a repayment commitment that includes both the principal and interest, which is known as the “cost” of the initial loan.
After that, borrowers would make regular payments for both interest and principal, as well as provide certain assets as security for the lender. Collateral, which will be utilized as repayment in the event that the borrower fails on the loan, might include stock, real estate, accounts receivable, insurance policies, or equipment.
Types of debt financing
The most typical forms of debt financing are as follows:
Traditional bank loans.
These loans are typically more affordable than loans from alternative lenders, despite the fact that they are frequently challenging to secure.
Popular with company owners is the government Small Business Administration. Although there are higher conditions for approval, the SBA makes loans through banking partners with lower interest rates and longer maturities.
Merchant cash advances.
This type of debt financing is taking out a loan from a different lender and paying it back with a percentage of your credit and debit card sales. Keep in mind that annual percentage charges on merchant cash loans are notoriously high (APRs).
Lines of credit.
You receive a lump sum of cash from business lines of credit, but you only use it when you actually need part of it. You just pay interest on the amount you actually use, and you won’t likely need to provide security, unlike with other forms of loan financing.
Business credit cards.
The operation of business credit cards is the same as that of personal credit cards, although they may contain features that are more advantageous to businesses, such as spending rewards that are absent from company credit lines.
Pros and cons of debt financing
Debt finance has advantages and disadvantages much like other forms of funding. Here are a few advantages:
Clear and finite terms.
You’ll know exactly what you owe, when you have to pay it, and how long you have to repay the loan if you use debt financing. Your payments won’t change from month to month.
No lender involvement in company operations.
Although debt financiers will become quite familiar with your company’s activities during the approval procedure, they won’t have any influence over them.
Tax-deductible interest payments.
You can save money on taxes by excluding debt financing interest payments from your taxable income.
The following are some drawbacks of borrowing money:
Repayment and interest fees.
These expenses could be high.
Quick start of repayments.
The first month after the loan is authorized, you’ll normally start making payments, which can be difficult for a startup because the company doesn’t yet have a solid financial foundation.
Potential for personal financial losses.
If your firm is unable to repay the loan, you might suffer a financial loss if you use debt financing. It may be disastrous to default on a loan and may lead to bankruptcy, whether you are putting your personal credit score, personal property, or earlier investments in your business at danger.
What is equity financing?
Equity financing is giving investors a stake in your firm in exchange for a portion of any future earnings. A transaction with a venture capitalist or equity crowdsourcing are two examples of how to get equity financing. If they choose this option, business owners won’t have to pay high interest rates or make monthly repayments. Instead, depending on the conditions of the sale, investors will be partial owners with the right to a share of business earnings and maybe even a vote in management decisions.
Types of equity financing
Typical forms of equity financing include the following:
A wealthy person who generously injects a lot of money into a company is an angel investor. A stake of the firm, or convertible debt, is what the angel investor receives in exchange for their investment.
An organization or an individual who invests money in businesses, typically high-risk startups, is known as a venture capitalist. Most of the time, the startup’s growth potential outweighs the risk to the investor. The venture investor could eventually attempt to purchase the business or, if it’s publicly traded, a sizable percentage of its shares.
Equity crowdfunding is the practice of using crowdsourcing platforms to distribute modest shares of your business to various investors. For these initiatives to succeed and receive money, significant marketing efforts and preparation are often necessary. The specifics of equity crow
defunding is laid forth in Title III of the JOBS Act.
Venture capitalists and angel investors are frequently extremely skilled, selective investors who won’t back any old project. Entrepreneurs require a pro forma with strong financials, some semblance of a functioning product or service, and a qualified management team to persuade an angel or VC to invest. If they are not already in your network, angels and venture capitalists can be challenging to approach, but incubator and accelerator programmes sometimes offer advice to firms on how to optimize their operations and attract investors, and they may also have access to their own networks.
As opposed to debt, equity frequently doesn’t require interest payments, according to Andy Panko, owner and financial planner at Tenon. Financial. But stock often has a higher ‘cost’ than debt does. Shareholders will still want compensation, [which] often entails paying dividends and/or making sure that equity prices rise favourably, both of which might be challenging to do.
Pros and cons of equity financing
There are benefits and drawbacks to employing stock financing to raise funds, much like debt financing. Here are a few advantages:
Well suited for startups in high-growth industries.
A firm that is poised for quick expansion is a great candidate for equity funding, particularly in the case of venture capitalists.
Rapid upscaling is much simpler to do with the quantity of money a firm may receive through equity financing.
No repayment until the company is profitable.
Angel investors and venture capitalists wait until you turn a profit before recovering their investment, in contrast to debt funding, which demands repayment regardless of your company’s financial status. When compared to debt funding, equity financing requires no payments even if your business fails.
The primary drawbacks of equity financing are as follows:
Hard to obtain.
For the majority of firms, equity funding is more difficult to get than debt financing. A robust personal network, a compelling business concept, and the necessary groundwork are needed.
Investor involvement in company operations.
Your equity financiers receive a place at your table for all business decisions since they invest their own money in your firm. You will lose your majority ownership in the firm if you sell more than 50% of it, whether to different investors or just one. As a result, you will have less said in how the business is managed and face the danger of losing your management position if the other shareholders opt to elect a new CEO.
How to choose between debt and equity financing
The choice between equity and debt funding ultimately comes down to the sort of firm you have and if the benefits exceed the dangers. Investigate your industry’s standards and what your rivals are doing. Look into various financial solutions to see which ones best meet your needs. If you’re thinking about selling equity, make sure you do it legally and in a way that lets you keep control of your business.
Many businesses blend the two methods of financing, in which case you may evaluate capital structures using the weighted average cost of capital, or WACC, calculation. The weighted average cost of capital (WACC) is calculated by multiplying the percentage costs of debt and equity under a certain proposed financing plan by the percentage of total capital that each capital type represents.