Debt vs. Equity Financing: What’s Best for Small Business?

debt vs equity financing small business

Debt vs. Equity Financing: The Pros and Cons
When it comes to small business funding there are a lot of options to choose from. Luckily, all of your funding options can be boiled down to one of two categories: debt financing or equity financing. This guide covers everything you need to know about debt and equity financing, including the advantages and disadvantages of each.

What is debt financing?

With debt financing, a borrower receives upfront funding from a lender and is obligated to repay the full amount (the “principal”) plus interest over a period of time, as specified in the agreed-upon terms.

What is equity financing

Equity financing is the process of raising capital by selling partial ownership of your company. Instead of paying back the principal of the loan plus interest, business owners trade a percentage of their company in return for funding. Lenders are then paid back with a portion of future profits.

What’s the difference between debt and equity financing?

The biggest difference between debt and equity financing is that debt financing doesn’t require you to give up a part of your business ownership. You’re simply borrowing capital from an outside source, just as you would be given outside financing for a mortgage or a car loan.

While debt financing keeps you safe from other stakeholders influencing your decisions and taking a portion of your future income, it’s riskier in that you will have to pay it back —- even if you default on the loan. For this reason, you’ll often have to put up some form of collateral.

So, what’s better for small business? The best one for your business depends on your goals, your business’s unique needs, and the reasons you’re seeking funding.

Debt vs. Equity Financing Pros and Cons

Advantages of debt financing

Disadvantages of debt financing

  • It does not dilute ownership.
  • Since you repay the principal of the loan plus interest, there is no direct claim on future profits. In most cases principal and interest are pre-determined amounts so there’s a higher degree of certainty.
  • Interest on debt can be deducted on your company’s tax return.
  • It’s less complicated in the eyes of state and federal securities laws.
  • It’s typically a much quicker time to funding.
  • The loan must be repaid, even if you default.
  • Interest is a fixed cost, ultimately raising the break-even point.
  • You’ll need to budget for repayments so that you have ample working capital to continue operations.
  • There’s often a restriction on which activities the loan can be used for, and it may prevent you from pursuing other financing options.
  • You’re typically required to pledge assets as collateral, and in some cases, you’ll need a personal guarantee.

Advantages of equity financing

Disadvantages of equity financing

  • There is no interest, and investors are only paid if things are going well. If the company dissolves, you don’t need to go into your pockets to repay your investors.
  • Because you won’t need to keep up with repayments, there’s more money available to fund business activites and growth opportunities.
  • Investors have a vested interest in the business’s success and can bring valuable skills, resources, and networks to the table.
  • It’s easier to acquire follow-up funding from your investors or outside lenders.
  • You will have a smaller share in the business. With each share, you’re also giving up a portion of your decision making power.
  • Raising equity financing can be demanding, costly, and time-consuming. It takes away time that could be spent growing the business.
  • Investors often want comprehensive background information on you and your business.
  • Reporting to stakeholders can be daunting and tiresome.
  • There’s a lot of legal and regulatory compliance to manage on an ongoing basis.

When should I use debt financing?

In general, debt financing is a better solution for short-term funding issues that arise during business operations (inventory management, payroll expenses, maintenance, etc.). If your business has been operating for a long time and you would like to maintain ownership, debt financing is the obvious choice. You can acquire the funds to meet your short-term needs without forfeiting future profit to equity holders. And because you’ve been in business long enough to understand your revenue streams, you’ll be able to forecast the impact of your financing and plan for future repayments.

However, you need to be careful with your debt to equity ratio, and your budgeting. When companies are too highly leveraged, making ongoing payments (aka “servicing the debt”) becomes more difficult. It also makes you a “riskier investment” in the eyes of lenders.

Putting your business in such a situation can hinder growth as there is less cash available to seize opportunities when they arise. And because most loans do not allow for varying payments, experiencing high interest during difficult financial periods increases the risk of insolvency.

Luckily, debt financing is easier to plan for, so there shouldn’t be any unwanted future surprises. Make sure you understand your budgeting needs up front, as well as the purpose for the loan. That way, you won’t ask for too much money on unfavorable terms. The last thing you want is to find yourself in a position where you cannot keep up with the payments. Your debt will only become more crippling.

When should I use equity financing?

Equity financing tends to be extremely effective during times of economic distress or in the early stages of business (especially pre-revenue). Investors are a great way to get a new business off the ground, especially if they have additional skills or resources to offer. This method carries much less financial risk than debt financing and still gives you the potential to outearn the profits you would have made as the only stakeholder.

Keep in mind that equity can cause issues for your company down the line. Any business owner who seeks equity financing eventually winds up diluting their stake in their company. Be careful with how much equity you plan to give out as other owners can influence your business decisions, even requesting that you surrender your stake in the business if difficulties working together arise.

The more equity you give up, the less control you have over the business. But giving up control can also work in your favor. In the early stages, business owners often wear many hats. It isn’t easy doing everything yourself and having other team members working towards the same goals can be a liberating experience. Just make sure that your investors will be valuable assets to your company, and that you’ll have enough equity left over for yourself and your business as multiple rounds of funding can be necessary during the lifecycle of your business.