Debt vs. Equity Financing

Debt vs. equity financing

In finance, a company’s capital structure consists of debt and equity. If you look at a statement of shareholder equity, you will see that equity is calculated as the difference between the value of the business’s total assets and liabilities. Debt financing and equity financing both have pros and cons. The choice depends on your startup’s financial situation and your goals as a business owner. 

What is debt financing?

Debt financing involves taking out a loan to fund your startup. As with any loan, you pay back the principal with interest over a specified time period. Term loans and lines of credit are two common types of business loans. This section examines the pros and cons of taking on debt. [Looking to borrow money? Check out our best picks for small business loans.] 

Pros of debt financing

These are some reasons a business owner might seek debt financing:

• Independence: Debt financing providers don’t get a say in how you run your startup. In contrast, equity financing requires you to hand over a stake in your company, which gives investors more sway over your decisions.
• No profit sharing: With debt financing, your profits remain entirely yours. With equity financing, investors are eventually entitled to a portion of your profits. 
• Easy budget forecasting: With a fixed-rate loan, your loan payments won’t change. That’s why budget forecasting is significantly easier when you opt for debt financing over other types of funding. With unchanging monthly fees, your future expenses are more predictable.

Cons of debt financing

These are some drawbacks of debt financing:

• Repayment: Unlike with equity financing, you must repay the money you receive from debt financing. If your startup doesn’t generate the cash flow needed to service the debt, you may end up defaulting on your business loan. Before you jump into an agreement, ensure that you know how to calculate loan payments and determine the debt payoff timeline.  
• Interest: Your monthly interest expenses could be quite large at a time when you must minimize your startup costs. The good news is that any interest you pay on debt financing is tax deductible. In the long run, that deduction could outweigh the immediate financial burden.
• Liability: Even if your business structure limits your personal liability in the event of a lawsuit, certain debt financing providers require you to put up your assets as collateral. If you fail to repay your loan, your lender may be able to acquire your assets.

What is equity financing?

Equity financing entails selling part of your company to an investor. The investor receives an ownership stake in the business in exchange for providing the capital your startup needs for growth. 

Startup investors include angel investors and venture capitalists. The main difference between angel investors and venture capitalists is that angel investors are often individuals that provide early-stage funding, while venture capitalists are firms that step in at a later stage. This section will weigh the pros and cons of accepting equity financing. 

Pros of equity financing

These are some reasons you may prefer equity financing as a source of capital:

• No repayment: You are not required to repay capital that you obtain through equity financing. Instead, investors are betting that they will make money through future cash flows or the sale of their stake. 
• No interest: Because equity financing does not require debt repayment, you do not have to worry about making interest payments. 
• Cash preservation: Unlike other types of funding, equity financing doesn’t cost you anything. This allows you to conserve more cash to grow your business, rather than having it go to interest payments. 

Cons of equity financing

The drawbacks of equity financing pertain to the ownership you give your investor:

• Loss of independence: Equity investors often take an active role in the startup. If your ownership stake is diluted through repeated offerings, you risk losing control of the business. 
• Profit sharing: An ownership stake entitles investors to a portion of your future profits. If you offer an investor 30 percent ownership in exchange for capital, you may need to set aside 30 percent of your profits for that investor someday. 
• Differences of opinion: You and your new shareholders won’t always agree on how the company should be run. If you don’t have strategies in place to solve these conflicts, it could cause tremendous strife within your organization.

Questions to consider before choosing debt vs. equity financing

Before you decide between debt and equity financing, you should ask yourself the following questions:

1. Which is more important: decision-making authority or minimal debt?

If you’re the kind of business owner who can’t stand the thought of sharing decision-making authority with someone else, you might see debt financing as your way out. However, if you forecast your budget and determine that you might struggle to repay debt financing, it may be best to play it safe and accept the loss of control that accompanies equity funding.

2. What are the current interest rates on debt financing?

It can be easy to overlook the impact of interest rates on your debt financing options. Even a small rate change can dramatically increase expenses in a high-interest-rate environment. Interest rates can make or break a new company, especially because it often takes years to achieve profitability as a startup. 

3. How much capital do I need, and what are the consequences?

If you need so much capital that you’re already worried about repaying the debt financing for it, equity financing may be a safer bet. However, when you provide equity in return for a large amount of capital, your investors will likely require a proportionately large share of your company. If your investor requests more than 50 percent ownership of your company, your decision-making authority could disappear. This is especially true when you are no longer a startup. 

4. Will my business structure easily allow equity financing?

Because equity financing requires you to give ownership shares to your investors, not all business structures can easily explore this funding route. For example, if your company is a partnership, its ownership structure may not be flexible enough to accommodate new shareholders. You can always change your type of business operation, but it’s a lengthy process. [Read more about how to dissolve a partnership agreement.]

5. Can I actually find equity financing?

Entrepreneurs often assume that equity financing is readily available, but that isn’t always the case. Not all entrepreneurs find investors who are interested in their companies. Other entrepreneurs find investors only after months of searching, so it might not work for you if you need cash fast.

On the other hand, debt financing providers will lend money to virtually any entity that qualifies. If you show a strong credit history, present a convincing business plan and prove that you can repay the loan, you might be in good shape for approval.

Whether you ultimately go with debt financing, equity financing or both, business growth might be quick to follow.

Mike Berner contributed to this article.