August 15, 2022 Last updated August 15th, 2022 182 Reads share

Debt Financing vs. Equity Financing: What to Know

Image Credit: pixabay.com

A small business owner typically has two basic funding options – debt financing and equity financing. Both approaches have different ways of providing the money and come with their unique pros and cons you should consider.

 

What Is Debt Financing?

Debt financing is when a lender lets you borrow money, and you have to pay the total amount with interest on a set period. It’s often through small business loans or loans online, either secured or unsecured.

Secured debt means you’ll be required to pledge collateral. It will be used to pay for the loan if the borrower defaults on it. Collateral may include real estate, inventory, equipment, insurance policies, and accounts receivable of your business. On the other hand, unsecured means you don’t have to pledge any collateral to get the financing you need for your business.

Pros of Debt Financing

The following are the pros of choosing debt financing to get the funds for your business needs:

Control

It’s vital to remember that a loan is only temporary. It will end at a certain period after successfully paying it back, including the interest. It means that the lender won’t have any opinion on how you should run your business.

Taxes

Loan interests are tax deductible. It means you can save money in the long run if you choose to get debt financing.

Predictability

When getting a loan, the principal loan amount and interest rate are typically stated in advance. So, it would be easier to include this into your business cash flow. 

Cons of Debt Financing

Debt financing consists of many benefits. However, it also has some cons, which you should also consider. 

Repayment

You’ll need to repay the money you received at a set period if you choose debt financing. If you have some experience with debt, you know exactly how it feels like to pay for it and the risks that may come with it. If you go through rough financial times, you might be unable to pay for your debt, resulting in dealing with debt collectors.

Interest Fees

You’ll have to pay interest fees when it comes to debt financing. Depending on your loan term and interest rates, your monthly debt repayment expenses could grow significantly. It’s a drawback since you’ll have to maintain low expenses as much as possible while you boost your company.

Liability

As mentioned earlier, some debt financing options are considered secured. Therefore, the lender will require you to put up collateral. Furthermore, this means that the lender can acquire your assets if you fail to repay the loan, which is a significant liability for your business.

What is Equity Financing?

Equity financing lets an investor have ownership rights in your business in exchange for funding. It can either be in the form of equity fundraising or close partnerships. Unlike debt financing, there are no fixed payments you’ll need to make if you go with this option.

Equity financing provides investors with a percentage of profits. It’s typically based on their stock. However, some small business owners also choose to have a hybrid agreement with their investors, which might include royalties and other benefits.

Pros of Equity Financing

If you are thinking about selecting equity financing, here are the benefits that can help you decide:

Less Risk

Equity financing carries less risk since you aren’t required to pay monthly payments to a lender. Choosing this funding option is advantageous if you’re a startup business that doesn’t have a lot of cash flow yet.

Cash Flow

You’ll be required to get money from your business cash flow if you have monthly loan repayments. Doing so affects the funds intended for business growth. However, this is not the case when it comes to equity financing.

Long-term Planning

It’s crucial to know that equity investors don’t usually expect a return on their investments immediately. They tend to have a long-term view and understand the risk associated with their investment. Most investors may lose their funds if the business fails.

Cons of Equity Financing

Just like debt financing, equity financing also carries some cons. 

Loss of Control

Adding investors to your company means you’ll have to give up some control. Equity investors have a say in your business, especially when it comes to making big decisions.

Potential Conflict

If you have multiple investors, they might not agree with each other during decision-making. Thus, if you choose equity financing, you must be willing to deal with potential conflict and different opinions.

 

To Sum It Up

Debt and equity financing can grant you the funds you need for your business. However, they are not the same. After knowing the pros and cons of these funding options, you now understand their differences. When it comes to choosing, it’s crucial to remember that the best financing option is the one that can support your business goals and needs.

Tiffany Wagner

Tiffany Wagner

Read Full Bio