Debt Financing Vs. Equity Financing: Pros and Cons

• Debt financing involves borrowing money and paying it back over time with interest.
• Equity financing is when investors pay you for a stake in your business.
• The type you choose will be determined by the nature of your business and its stage of development.
• Read more stories from Personal Finance Insider.

When small business owners need to raise capital for their business, they have two options: debt financing or equity financing. These are very different approaches to fundraising, and each has its own pros and cons. Here’s an overview of how they work, the pros and cons of each, and actionable insights on how to choose the best option for your business.

Debt Financing vs. Equity Financing: At a Glance

Whether your business needs money to start, scale, invest in your processes, or anything else, debt financing and equity financing are two viable financing choices.

• Debt financing: This is when you borrow money and pay it back over time with interest. Loans, lines of credit and bonds are some of the most common forms of debt financing.
• Equity financing: It is when you take money from an investor in exchange for an equity stake in your business. Venture capital, crowdfunding, and initial public offerings (IPOs) are among the most common forms of equity financing.

What is Debt Financing?

Raising money for your business through debt financing involves borrowing money, either from a bank or investors, and paying back the principal plus interest over a set period of time. Although this type of financing can sometimes come with restrictions, it generally allows you to retain full ownership and control of your business.

Here are some of the most popular forms of debt financing you can pursue in your quest to raise capital:

Loans

Loans are among the most common forms of debt financing for small businesses. These are available from banks and

credit unions

, and may be supported by the United States Small Business Administration (SBA). You designate the amount you need, then the lender determines your creditworthiness and sets the terms, which can vary widely. Your financial health, the amount of principal and the type of collateral you use are all factors that affect the cost of borrowing. Once you’re approved, you receive the funds and then repay the money with fixed payments plus interest.

Lines of business credit

A small business can open a business line of credit and draw funds from it when funds are needed to grow, supplement cash flow during times of seasonal stress, or cover other short-term business expenses. These lines are generally unsecured, which means you are not required to provide collateral. Instead of a large lump sum loan, a business line of credit is a fund you can draw from and repay as needed.

Obligations

Bonds allow investors to lend money to companies. Instead of going to a bank, the business owner sells bonds to investors, agreeing to redeem the face value of the bonds on a specific date and pay interest at regular intervals along the way, usually one or two times a year. Bonds can be either secured (backed by collateral) or unsecured. Maturities can vary from one year to 30 years, with longer-term bonds paying higher interest rates.

When is debt financing better than equity financing?

If your business is growing rapidly and you’ll be able to repay the loan plus interest while making money, debt financing is probably a good choice. It’s also your best bet when you’re comfortable with the risk of losing the collateral you’re required to provide. Also, if you don’t want to share future profits with investors and prefer to make a payment on a loan, debt financing is the way to go.

Retaining control of your business may be the best reason to choose debt financing, according to Carrie Daniels, partner at B2B CFO.

“Debt financing is a preferred method of raising capital for business owners who don’t want to cede ownership or try to please investors,” Daniels said. “You’ll probably end up doing both if you go for equity financing.”

What is equity financing?

Equity financing is a completely different way of raising capital compared to debt financing. Instead of borrowing money and paying it back, you sell shares of your company to investors who then become co-owners.

How does equity financing work?

To raise capital through equity financing, you must first find investors interested in your business. They will review your financial information, your business plan and may visit your establishment. If they decide to fund you, they will give you an agreed amount of money for a stake in your business. The amount you can raise and the percentage of ownership that accrues to the investor depends on the value of your business. Essentially, investors pay a share of your company’s future profits.

Here are some of the most common ways to raise funds through equity financing:

Capital risk

Venture capitalists are individuals or groups of investors who can be good sources for raising capital, especially if other options are not available to you. They would look at the business and if they thought they could make money from the deal, offer you a cash injection for part of your business.

Crowdfunding platforms

You can leverage the power of the internet and sell small amounts of your business through crowdfunding. It is an online method of raising capital where, in exchange for supporting the business, investors receive an equity stake in the business proportional to the amount of money they have invested in it. Equity crowdfunding can provide access to a much larger group of potential investors than a company could otherwise tap into. Some notable crowdfunding platforms include AngelList, WeFunder, and StartEngine.

Initial public offerings

As a private company, you can sell shares of your company to investors through an initial public offering of shares, or IPO. Choosing this path means that your company would go from “private” to “public”.

When is equity financing better than debt financing?

If you’re running a startup in a high-growth industry (attractive to venture capitalists) and want to scale quickly, equity financing may be a better option for you than debt financing. It is also a good option if you find yourself in a situation where it is simply not possible to borrow money.

“If a company needs cash and can’t qualify for debt financing, equity financing can raise the funds it needs,” Daniels said. “Otherwise, the company could miss valuable growth opportunities.”

Also remember that debt financing requires a business to start repaying the loan almost immediately. Equity financing can sustain a loss-making business until it starts making a profit. This is advantageous for startups with stretched cash flow.

The bottom line

It is possible to raise capital for your small business with debt and equity financing. There are several factors to consider when choosing the best option for your business. By understanding each of them thoroughly and the impact of each, you can make the decision that best supports your long-term business success.

Susan McCulluh

Susan McCulluh