Equity financing is often compared to debt financing, because they are the two most common ways to raise capital for a business. While equity financing is the exchange of shares for upfront capital, debt financing is the agreement to pay future interest on upfront capital (aka debt). At their core, these two financing options result in the same thing: the lender or investor takes on the upfront risk by giving you capital that you don’t have, and you repay that risk as your business makes money. However, the repayment is where equity financing and debt financing are starkly different.
With debt financing, regardless of how well your business is doing, you owe that lender their money back, plus interest. Often, lenders will require collateral, like real estate or a vehicle, to ensure that if you default on the loan, they still have a way to recoup their money. In other words, there’s really no way to get out of repaying a loan and it can hurt your cash flow for years.
Equity financing does not require you to take on debt, or make monthly loan payments to repay a lender, which is a major selling point for most new small business owners. However, if your business does very well, you will end up owing an investor a lot more if you want to buy them out and regain ownership of your company.
Picture this: you need $50,000 to make a major purchase order and ramp up production. If you took on a business loan with a 10% interest rate and paid it off over 3 years, you can expect to pay about $8,000 in interest. On the other hand, imagine if your business was valued at $1 million and an investor gave you $50,000 for 5% stake. Then, if your business grew to be worth $5 million three years later, you would owe that investor $250,000 to buy out their shares in your company. From a sheer financial look, debt financing is a much better deal.
However, there’s one more unique benefit to equity financing: your investor becomes a stakeholder in your company and can often add additional value in the form of guidance, which can help your business grow far faster than it could have without an experienced investor on board.
While both equity and debt financing have their advantages, your decision may actually come down to available options. Debt financing is often not available to young businesses as they typically lack a strong credit profile and history of meeting expenses. At the end of the day, both equity and debt financing can help take your business to the next level- as long as you make decisions that are conscious of your future business, you can be sure you made the right choice.
Learn more in our guide to debt financing vs equity financing.