What Is the Difference Between Debt Financing and Equity Financing?
Businesses large and small usually need some assistance in either starting up or expanding existing operations. Gaining needed capital can come from either debt or equity financing. Equity financing does not require the owner to pay anything back and comes from investors. Debt financing comes from a lender and has a finite amount of time to pay back the loan on interest, and some loans require collateral.
There are several options between equity and debt financing a person can choose from for their business. New and existing companies may have different needs and places to raise capital. Knowing which one to use depends on critical variables. Some include the age of the business, the experience of the business owners and any tax implications. Other factors you will need to consider are the existing debt and assets the business owns, as well as short-term and long-term goals for you and your company.
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Equity financing is money given by investors to a business for shares in the company (you must incorporate the company before the business can offer shares). For businesses not incorporated, the exchange comes in the form of portions of ownership related to management and other operations within the company.
Examples of Equity Financing
- Personal investments, family and friends. Many business owners invest in their own companies. However, this is not always possible. When the need for equity financing grows beyond personal investing from the owner, friends or family, the next step is to design a business plan to present to investors for equity financing.
- Other forms of equity financing come from angel investors. They invest a large amount of capital for a significant share in the company.
- Venture capital companies often put large amounts of funds into a business at a stage beyond a startup. Companies that show considerable projections in terms of growth for the possibility of a high rate of return are attractive to these investors.
Pros of Equity Financing
- The business carries less risk. Investors carry the most significant portion of the risk. If the company fails, an owner does not have to repay equity financing. This is an excellent option for businesses with a strong valuation or with little credit for debt financing.
- The business can use added capital elsewhere. If there are no other loans, the business can reinvest the profits from the initial equity financing. This is a good option if the business projects a future expansion with stable projections in growth.
- There are no interest payments. There aren’t interest payments with equity financing and this leaves more options to use capital.
- A business owner can learn from an investor. When you enlist investors, they come with experience and knowledge to share with you to better your business.
Cons of Equity Financing
- Gaining capital takes a lot of time. Compared to other loan options on the market, equity financing can take more time depending on business plans, proposals, and other specifications to solidify agreements.
- A business owner may have to give up some control. You may need to discuss major decisions with investors.
- You will share profits. At some point, investors will receive their share of earnings as per your agreement.
- You may need to change the terms of the agreements. Changes in the business will require revisiting aspects of the company. This creates potential conflicts between you and the investor(s).
Debt financing is gaining funds through a loan to finance business needs such as remodeling, new equipment, or expansion such as an acquisition or other needs. Once approved, the business owner has to pay back the debt with interest within a set period determined by the lender. Typically a lender will require the owner to write a business plan or at least provide documentation showing a stable history with profitability. This includes recent sales, orders, expenses, and possibly previous tax returns.
Examples of Debt Financing
- Lines of credit. These are unsecured loans and are associated with higher interest rates.
- Secured debt loans. They are backed by an asset of the company as collateral. The collateral can be a valuation of assets the business owns at the time of the agreement.
- Issuing bonds if the business is incorporated. The company can issue bonds (or sell the debt) for investors to purchase. By doing so, the investors become the creditors (lenders).
Pros of Debt Financing
- Debt financing is faster. If a business is in a bind and needs quick funding, this is a good option.
- You will have control. A business owner will not have to give up control over decisions for the business.
- You keep ownership of the business. The owner of the business will not have to give up ownership. This may be best for a relatively established company with a solid working team.
- Interest tax deductions for business expenses. Interest paid on loans is tax-deductible to the business. If the interest rate is low enough, then the business may benefit from the additional tax deduction depending on the company’s finances and tax circumstances.
- Interest Rates are usually lower. Interest rates on a secured loan are generally lower versus the rate of return on an equity loan.
Cons of Debt Financing
- Repayment terms are quick. Depending on the terms of the loan, payments may begin immediately, regardless of how well the business is going.
- Restrictions from lenders. Some lenders may have stipulations on where you can use the money. They may also set limits on attaining additional capital elsewhere.
- Defaulting means losing assets. If the loan is secured by valuated assets and the business defaults on the loan, then the business might lose those assets.
- Business or personal credit may be tied up. If the business has an existing loan and at a later time needs more financing before the loan is paid, funds may be limited. Based on the debt to income ratio of either the business or the business owner, a lender may not finance additional loans.
- Liability between owners. If the business is not a sole proprietorship with more than one owner (limited liability or corporation, for example). There are implications in terms of liability of debts.
If you own a business with stable profits and hold enough collective experience through yourself and your team, then a business loan may suffice. This depends on how substantial the investment is. However, if you have a startup with minimal experience and credit, an equity loan may be best for you. Having an investor provides less risk, with added educational benefits. It is always wise to seek counsel from those who are more experienced than you are. Either way you choose, consult your certified public accountant so you know what tax implications and liabilities you may have, as well as a business law attorney for questions on entity formation and taxation, before you begin your financing journey.
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This post was updated October 17, 2019. It was originally published October 17, 2019.