It’s finally time: After months, if not years, of fleshing out a startup idea, you’re ready to turn your dream into a reality. Well, you’re mentally ready, at least. Before you can truly move forward, you have to find the thousands – sometimes hundreds of thousands – of dollars often required to launch a startup. Among the options available to raise the needed startup capital are debt financing and equity financing. While you can pursue both, you should understand their differences, drawbacks and advantages before getting started.
Debt vs. equity financing
The primary difference between debt and equity financing is whether you pay to obtain them. Debt financing requires you to repay the money you receive, with interest, over an extended period. Equity financing requires no repayment, because you give up a portion of your company to the investor in exchange for the capital.
Some experts argue that, despite debt financing requiring you to repay loans and interest, equity financing may cost your company more money in the long run. These experts believe that the better you expect your company to perform, the more money you stand to lose when you offer investors a piece of your business. This distinction may be the most abstract in the debt vs. equity financing debate.
What is debt financing?
Debt financing means borrowing money for your company and repaying it with added interest fees. Standard loans are a type of debt financing, as are many everyday funding opportunities, including mortgages.
For example, let’s say you need $50,000 to launch your startup. If you acquire this money from a two-year loan with a 10% interest rate compounded annually, then, according to the compound interest formula, you will owe $1,050 on top of your loan repayment. This is the calculation for the monthly payment:
($50,000 + $1,050) ÷ 24 = $2,127.08
Pros of debt financing
These are some reasons a business owner might seek debt financing:
- Independent decision-making. Providers of debt financing don’t get a say in how you run your company. Equity financing requires you to give your investor a stake in your company, which gives them a say in all key business decisions.
- No profit-sharing. When you opt for equity financing, the stakes you give your investor entitle them to a portion of your profits. With debt financing, your profits remain entirely yours.
- Easy budget forecasting. Once the interest rate for your debt financing is set, it won’t change. That’s why budget forecasting is significantly easier when you opt for debt financing over other types of financing. 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 repay the money you receive from debt financing. Anybody who has ever taken out student loans or a mortgage knows the inherent risk of this arrangement. If you fall on hard times, you may become unable to repay your debt and soon find yourself dealing with debt collectors.
- Interest fees. Another key distinction between debt and equity financing is that only debt financing generates interest fees. Depending on the interest rate and term of your loan, your monthly interest expenses could grow quite large – and you need to keep your expenses as low as possible while you’re growing your company. However, 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 will 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 means selling part of your company’s equity to an investor. The investor provides the capital your company needs for growth while receiving a stake in your business.
For example, if your startup needs a substantial cash infusion to get up and running, you might search for angel investors or venture capitalists who, in return for their capital, will want a stake in your business. If you decide to give your new investor 30% ownership of your company to receive their capital, that investor now has a seat at the table for all future business decisions.
Pros of equity financing
These are some reasons you may prefer equity financing as a source of capital:
- No repayment. Investors will not require you to repay the capital they give you when you obtain it through equity financing. The logic is that investors will fund your company with the expectation that it will grow substantially. The large buyout your investor will receive in the long term, whether from you or another company that has bought yours, theoretically makes their risk worthwhile.
- No interest fees. Since equity financing does not require repayment, there are no interest fees for you to pay.
- More capital. When you choose to grow your company through equity financing, you gain capital. You also expand your capacity to obtain even more capital since, unlike with other types of funding, you’ll spend no money to obtain equity financing. Since you’ve kept all your cash, the amount of money available for you to spend on additional resources is unchanged.
Cons of equity financing
The drawbacks of equity financing all pertain to the ownership you give your investor:
- Decision-making. Every time you obtain equity financing, your funding source thereafter owns a portion of your company. As such, you’ll need to consult your funders on all key business decisions.
- Profit-sharing. A portion of your profits will flow to your investors. If you offer an investor 30% ownership in exchange for their capital, you will have to set aside 30% of your profits for that investor moving forward.
- Difference of opinions. You and your new shareholders won’t always be on the same page in terms of 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 choose between debt and equity financing (or obtain funding through both by determining a debt-to-equity ratio), you may want to 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 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. After all, the $1,050 interest on a $50,000 loan in the above example is only 2.1% of the loan’s total value. However, any added expenses can make or break a new company, as some businesses may take years to become profitable.
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% ownership of your company, your decision-making authority could even come second to theirs.
4. Will my business structure easily allow equity financing?
Since 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.
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 will only find investors 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 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.