When a company wants to raise capital, they tend to focus on two main options: equity financing and debt financing. These are not the only financing possibilities available, but they remain the most popular because they offer numerous benefits to small business owners.
This article will explain what equity and debt financing are, their main differences, advantages and disadvantages, and how you can use each (or a combination of both) to grow your business.
What is equity financing?
Equity financing means you sell a portion of your company’s equity (or a stake in it) in return for capital from investors who believe you can produce profits. For example, you can offer 15% of the ownership of your business in exchange for money.
A popular mode of equity financing is making a deal with one or more venture capitalists (entities or individuals) or angel investors. These interested groups are often very discerning, having experience with high-risk startups and companies with unexploited potential. Some companies also use equity crowdfunding platforms, selling small shares to numerous investors.
In short, the most popular sources of equity financing are:
- Crowdfunding: Funding a project or venture by inviting large groups of people to contribute small amounts of money.
- Angel investors: Individuals who provide capital for startups and businesses in exchange for debt or equity.
- Venture capital firms: Investment companies that fund and mentor startups and young companies.
- IPOs: Selling shares on the public market to attract investors without giving up a controlling stake.
- Corporate investors: Companies that invest in other companies buying stock and often installing new management.
Why would you choose equity financing?
Unlike other forms of financing, you are not required to repay the money when you take equity financing. There are also no interest charges or additional burdens on your company when you choose this option. What this typically means is that the business has more capital available to re-invest and grow. Equity financing is also an excellent option for startups working in high-growth industries because it can help them scale rapidly.
Of course, there are some downsides to equity financing, too. In order to gain access to funding, you will be required to provide equity investors with a percentage of your company (the number will vary depending on what you negotiate). These partners will therefore be able to influence some of your business decisions, as you will have to consult with them every time you want to do something that affects the company.
Equity financing can be challenging to obtain for most businesses, as it requires a strong network and a solid business plan. Another downside is that you can only remove equity financing investors by buying them out - typically for a much higher amount of money than they had originally given to you.
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What is debt financing?
Debt financing is similar to a small business loan. This option consists of companies borrowing money from an outside source and giving it back using monthly interest payments. Traditional types of debt financing include bank loans, SBA loans, merchant cash advances, business credit cards, and lines of credit.
With debt financing, there are usually restrictions on what you can do with the money. Some lenders will also ask startups to put up assets, such as real estate, inventory, equipment, and accounts receivable as collateral. In the case the borrower defaults, the lender can use these as part of the repayment obligation.
The most popular sources of debt financing are:
- Business lines of credit: An account that lets you access a pool of funds from which you can withdraw when needed (and only pay interest for that amount).
- Invoice factoring: A type of invoice financing where you sell outstanding invoices to a third party to fund cash flow.
- Term loans: Loans from banks for a specific amount and repayment schedule, as well as a fixed or floating interest rate.
- Business credit cards: Credit cards issued to business accounts that have a limit based on your business’ credit score.
- Personal loans: A type of loan that doesn’t require collateral or security and must be repaid with an interest.
- SBA loans: Small business loans partially guaranteed by the government but issued by private lenders.
- P2P (peer-to-peer) lending services: A way for anyone to directly lend money to individuals or businesses without the need for any financial institution.
Why would you choose debt financing?
If you choose to use debt financing to support your business, the lender does not have no control over your operations. This is probably one of the most significant benefits of this type of financing. Also, the interest payments are tax-deductible and do not fluctuate (meaning you can forecast expenses more easily). When you finish with your loan payments, your relationship with the financier is over, and you have no additional obligations towards them.
On the other hand, if your company faces hardships or you don’t grow as fast as you had anticipated, you might have trouble repaying your debt financing. Interest fees for debt financing are pretty steep, and you usually have to start making them the first month after the loan is approved and funded.
Another disadvantage is that debt financing has the potential to cause you personal financial losses. Many lenders will require you to use your own assets as a guarantee for the loan. If you are unable to pay, you could risk your credit score and personal property (or have to declare bankruptcy). It is therefore recommended that you seek lenders that do not ask for personal guarantees for providing loans. For instance, lenders like Fundsquire do not ask for any personal guarantees or collateral when providing debt financing.
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We can help. Fundsquire has financing solutions for every step of your growth journey.
An example of equity and debt financing
Suppose you own a company looking to purchase new equipment and build a new factory. You calculate the total capital you need to support the growth is £40 million. You then decide that the best way of raising funds is to use a combination of equity financing and debt financing.
To deal with equity finance, you decide to sell a 10% stake in your business to an investor who, in exchange, will give you £15 million in capital. You then apply for a £25 million business loan from a bank. You obtained these funds in exchange for the investor taking some ownership, and you will also have to make monthly payments to the bank to cover the rest.
When to choose equity financing or debt financing
Ultimately, you can combine equity financing and debt financing as you think is best for your company. Companies can incur both these options at the same time and using different amounts.
If you choose to use more debt financing, you will have higher monthly expenses but retain ownership of your business. Conversely, if you pick equity financing, you will have more cash in hand but less control over your company decisions.
Which one is cheaper?
Debt financing can be cheaper than equity financing, although it depends on how well your business performs. In some cases, the opposite can be true as well. Specifically:
- If you choose only equity financing and your business makes no profits and closes, you won’t lose any money.
- If you choose debt financing and things go awry, you will still need to make the loan payments (in many cases, at the expense of your personal assets).
In the above situation, debt financing costs more than equity financing. However:
- If you sell your company for millions of dollars, you will have to pay your shareholders a percentage.
In this case, the amount paid would be much more than if you had kept the ownership and used a business loan.
Which one is riskier?
The answer to this question also depends on the specific situation of your company. If you are not profitable, debt financing is riskier because you need to pay the loan and its interests. However, the answer is not that simple. If you opt for equity financing and you don’t turn a good profit, your investors can try and negotiate for cheaper equality - or abandon your project entirely.
Looking for funding?
We can help. Fundsquire has financing solutions for every step of your growth journey.
Wrap up
Both equity financing and debt financing are excellent ways for a business owner to obtain the necessary funding to grow their business.
Which one you end up choosing, or how you split them, is up to your business needs and preferences. As we saw, there are clear advantages and risks with both. With equity financing, you give up a portion of your ownership but have no obligation to repay the funds given to you. With debt financing, you are obliged to repay the monthly instalments and their interest, but you are in full control of your company.
Many startups will pursue equity financing because it can provide them with quick funds that are not tied to their personal assets. The price is, as we saw, giving up some equity. Companies that are more established tend to use debt financing because they know they will have fewer problems repaying the loan.
Fundsquire provides non-dilutive growth funding for startups and SMEs. No path to business success is the same. Contact us today to learn how we can help you access equity and debt funding.
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No business or path to success and growth is the same. If you have a question, are ready to apply or would like to learn more about Fundsquire, please contact us today.
