Choosing the right type of financing is essential to the success of your business. There are two main options: debt and equity. Which one is best for your business? Here’s an outline of the advantages and disadvantages of each option so that you can make an informed decision.
What is Equity Financing?
With equity financing, investors purchase your business shares to receive a portion of its profits. Your business receives capital in exchange for a percentage ownership of your company. This is a common source of financing for larger companies since it allows them to grow their business without taking on any debt.
The primary benefit of equity financing is the aforementioned funding of operations without accruing debt. This means you don’t have to repay a loan and risk less because you don’t have to make any interest payments.
What is Debt Financing?
With debt financing, you borrow cash from a lender and promise to repay with interest. Debt financing is the most common type of financing across many industries, including small businesses.
Debt financing can take a few different forms, including a loan, a line of credit, or a credit card. Debt financing is a good option for companies looking to expand quickly since you don’t have to give up a portion of your business. Instead, you promise to repay your lender with interest.
Factors to Consider When Choosing Between Debt and Equity Financing
You should keep in mind a few things when deciding between debt and equity financing:
- First, consider your company’s current cash flow. Debt financing is necessary if you aren’t making enough to cover your expenses.
- Consider your company’s long-term goals. If you have a very specific vision for how your company should operate, you should probably stick to debt financing, as shareholders sway company decisions under equity financing.
- Lastly, always keep in your priorities. If you value control more than the type of cash flow debt financing might get you, go with debt financing. If you value freedom from debt, equity financing is your best bet.
Debt Vs. Equity Financing Pros and Cons
Each option has its appeal, but they also have downsides. Let’s list them out.
Pros of Equity Financing
- No repayment is required
- No interest payments
- Doesn’t require a credit check
- Offers flexibility
- You gain smaller capital from a few investors instead of getting a more significant amount from a single lender. This means you have more sources of income and, if someone falters in payment, your business isn’t at risk.
The Cons of Equity Financing
- It’s more complicated to obtain
- Equity dilution is a risk
- Equity dilution is a risk for investors, as well, which makes them more cautious
- Less control over the company
The Pros of Debt Financing
- It’s easier to find investors
- Requires little to no equity
- No repayment is required
- Higher interest rates
- More control over the company
The Cons of Debt Financing
- Interest payments
- Debt repayment could hinder growth
- Repayment could hurt your cash flow if you don’t have a large enough profit to cover the interest payments and the loan itself
- Debt could decrease your company’s value
Debt Vs. Equity Financing Examples in 2022
Debt financing does not dilute the ownership of the business, but it does require regular payments of interest and principal. Equity financing can provide a source of ongoing capital, but it comes with the cost of giving up partial ownership of the company.
As businesses continue to navigate the challenges posed by the pandemic, many will be forced to make tough decisions about how to finance their operations.
Conceptualizing economics into reality is difficult. Both equity financing and debt financing have their appeals but actualizing that without experiencing them makes the possibilities seem murky and unsure.
You need to be firm on your decision for your business financing, so let’s go over two examples to hopefully assist you in visualizing your options.
Situation 1: A small business owner takes out a loan from a bank to finance the expansion of her product line. The loan includes an interest rate of 4% and must be repaid over five years.
Situation 2: A start-up company sells shares of stock to venture capitalists to raise capital for its operations. In exchange for their investment, the venture capitalists receive a percentage of ownership in the company.
Now, in which situation would a company prefer equity over debt financing?
Situation 2 best fits equity financing because it doesn’t require debt repayment.
In general, a company would prefer equity financing over debt financing if it is not generating any profit. Equity financing will not require you to repay if the company is not profitable, whereas debt financing will require you to repay, regardless of profitability.
A variety of situations will require a variety of solutions. Sometimes, they are fairly straightforward.
Let’s say that a restaurant chain is going to open a new location. To do this, the company will need a large sum of money to cover the costs. If the company wants this done more immediately and has not saved up enough money, debt financing would allow the company to open the new location and continue with its operations.
In this situation, the immediacy of debt financing won out, being the simplest solution. If the company had been willing or able to wait and save up, equity financing would have been a solid option, as well.
Debt financing is when a company borrows money from a lender, such as a bank to finance its operations. The company agrees to repay the principal amount of the loan and interest on the debt. Companies with good credit ratings typically use this type of financing and can offer lenders a reasonable return on their investment.
Equity financing is when a company sells shares of ownership to investors in exchange for cash. These shareholders become partial owners of the company and are entitled to receive dividends (a portion of the company’s profits) and voting rights on important decisions affecting the business.
Equity financing is often used by early-stage or high-risk businesses because they may not be able to qualify for loans.
Whichever financing option you choose will depend entirely on your company’s needs, but now you’re equipped with the information you need to determine your needs and make that decision.