Debt vs. Equity Financing: Advantages and Disadvantages
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When starting up a new company you will most likely need outside financing. Two main sources of external income include business debt financing or financing from equity investors. Make sure you’re aware of the differences between debt vs. equity financing so that you can make an educated decision. You will have to weigh out debt vs. equity advantages and disadvantages. You should also question if debt or equity financing is more expensive? Different businesses have different needs; it is up to you to determine which will better suit your business. There is certainly no right or wrong answer.
Debt Financing Overview
Debt is essentially borrowed money. Most of us encounter some form of debt in our day to day lives; mortgages, car financing and loans, and credit cards are some example. It is no different for a business. With debt financing, your business would be borrowing an agreed amount of money from a lender which will be paid back in a predetermined period of time. Small businesses can use lines of credit, working capital loans or a number of other financing programs. Usually smaller companies, such as restaurants, manufacturing and retail companies, will find debt financing to be more favorable for their needs. In order to get approved by lenders you will typically need a good credit score, business history, financial records and a strong business plan. Evaluate debt vs. equity financing pros and cons before making any decisions.
Types of Debt Financing
Term Loans
Banks, credit unions or alternative lenders provide the full amount of capital requested upfront and repayments are made over an agreed amount of time.
Credit cards
Funding coming from a bank or financial institution. There is a limit, usually based off your credit score, and the money must be paid back over a period of time with monthly payments.
Merchant Cash Advance
Businesses that receive a majority of their income from credit cards allow lenders to take a daily percentage of credit card earnings.
Invoice Financing
Capital is given up front to a business in exchange for guaranteed incoming money, from your invoices and account receivables.
Advantages of Debt Financing
- One of the biggest advantages to debt financing is you maintain ownership and control over your business.
- You keep your company’s profits.
- Loan agreements are temporary. Once you have paid off your loan you are free from debt and contracts. As long as the loan is paid back in the agreed upon period time and good credit is maintained, you can take out future loans if necessary.
- Business debts are tax deductible.
- In the long run interest rates on loans will usually cost you less than giving up a percentage of your company.
Disadvantages of Debt Financing
- The money must be repaid regardless of the success of the business.
- Startup companies already have high expenses and can sometimes take a few years before turning over a real profit. Monthly debt payments can put a lot of stress on a new business.
- Too much debt negatively affects the value of your company making future loans difficult.
- Some contracts may have increasing interest rates over a period of time.
- Your personal belongings such as homes, cars, and personal finances can be taken if used as collateral for the loan, and you fail to make payments.
- Lenders may place unfavorable limitations on what the loan can be used for.
Equity Financing Overview
Equity financing is selling a percentage of your business to an investor in exchange for funding. No repayments will be made. The investor will receive a portion of the profits, depending on how much stock they hold in the company. Typically the more money you ask for, the larger the stock will be. The terms of the agreement should be agreed upon and documented properly. This method of financing is better for larger companies with the potential to generate high revenue such as tech companies. Investors will analyze and scrutinize your business plans and strategies. They are often skeptical and look for ambitious goals and plans. You will want to make sure you properly weigh out debt vs equity financing pros and cons in order to ensure you make the best decision for your business.
Types of Equity Financing
- Angel Investors – Private investors or associations that often invest large amounts of money into your company but will usually require ownership of a large portion of your business.
- Relatives and associates – Investments from a private investor. These are typically small payouts in exchange for a small stake of the company.
- Venture capital firms – Firms that are known to invest millions in to startup companies that exhibit potential.
Advantages of Equity Financing
- Equity financing can bring in more up front capital.
- Sometimes a strong business plan can be more important than your credit score or years in the business.
- You can build strong lasting relationships with your investors. They can offer outside perspective and expertise to your new business. They can also grant you access to new connections and networking.
- There will be more flexibility in your spending because you won’t have the stress and strain of monthly debt payments.
- Investors usually take on most of the early risk of starting a new business.
Disadvantages of Equity Financing
- Loss of full control of your business.
- Split of profits.
- You could potentially be voted out if you don’t hold enough power and votes within your company
- Investors may have control over major decisions
- Finding investors and maintaining working relationships can be time consuming.
Knowing your options and the needs of your business can make all the difference when it comes to choosing between debt vs. equity financing. No one knows the needs of your business better than you. While both methods can provide you the capital you may need, take the time to evaluate the pros and cons of debt vs. equity financing. Make an educated decision because it is one that will affect your business for years to come.
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