When you seek capital for your business, generally, there are two types of financing you can obtain: debt vs. equity.
Of course, the type of business financing that’s right for you will depend on various factors. On the one hand, taking on debt, such as a business loan, allows you to keep your business ownership. But debt financing will also cost you money.
Here’s a closer look at the differences between debt and equity financing, the pros and cons of each financing option, and how to determine which is best for your small business.
What Is Debt Financing?
What is debt financing? Debt financing usually takes the form of a loan. This loan might come from a bank, a commercial loan company, or a friend or relative. Business credit cards and business lines of credit are also considered different types of debt financing.
In the most basic debt financing scenario, a lender offers you capital, which you’ll pay back over an agreed-upon amount of time, with interest. After you’ve paid back your debt, your relationship with the lender ends.
The downside to debt financing is in the case where you aren’t able to pay back your debt in full with interest. If that’s the case, the lender can take away your assets, garnish wages, or put a lien on your home. Additionally, it’s possible for your credit score to be negatively affected.
What Is Equity Financing?
With equity financing, someone invests money in your business in return for a percentage of ownership.
Equity financing may come from a private or angel investor, a friend or family member, or by selling shares in your business to investors. There are also institutional forms of equity financing, such as venture capital. Venture capital funds aggregate and manage money from wealthy investors, then invest it in fast-growing businesses.
Equity financing typically involves investors giving capital to young but promising businesses in exchange for ownership in the company. Those investors want the pay-out if the company they invested in goes public or gets acquired.
However, oftentimes equity financing also involves giving the investor some say in how your company is run. Many startup owners choose to give their investors a seat on their Board of Directors, giving investors some influence over the business’s direction.
Debt vs. Equity Financing: Pros and Cons
Which form of financing is best for your business, debt, or equity? Before you choose debt vs. equity for your business, you need to know a few things about how they work.
Pros of Debt Financing
- Better for small amounts of capital: Debt financing is typically the way to go for smaller amounts of capital. Even angel investors rarely make investments under $100,000, and venture capitalists will only consider investments in the millions of dollars. If you need, say, $10,000 or $25,000, you will need to look into debt financing.
- You can get funding faster: Need money in a hurry? Getting debt financing is a much faster process than finding equity capital, which involves identifying and pitching to investors, then drawing up legal documents and other paperwork regarding the equity. In contrast, online debt financing solutions can get you funded in a matter of days.
- You control your business: With debt financing, the lender has no business ownership and has no decision-making power. Once you pay off the loan, your relationship with that lender is over (unless you fail to pay off your loan and the lender put a UCC lien on your business).
Cons of Debt Financing
- You have to pay back the money: Borrowing money from a lender doesn’t come for free. You’ll need to pay interest on top of the amount you borrowed from the lender, and if you don’t have sufficient cash flow, you could risk not paying your debt on time. Failure to pay back your debt could result in hefty fines, or even cost you a few important assets.
- Can be hard to qualify for: Not all debt financing is equal. If you are seeking a loan from traditional financial institutions like a commercial bank, you may have a harder time getting a loan. That’s because banks tend to have strict eligibility requirements for businesses that need financing. If you don’t have a good credit score, strong annual revenue, and/or sufficient cash flow, you’ll most likely be turned down by a bank. Fortunately, there are a few online lenders that you can turn to—but again, there’s no 100% guarantee that you’ll get debt financing.
Pros of Equity Financing
- Better for larger amounts of capital: Do you need a mid-range amount of capital (such as $100,000 to $1 million) and want expert guidance in addition to the money? Equity investment through an angel investor could be the way to go. Angels are often experienced (or retired) business owners seeking to invest in industries where they have expertise. Many of them are willing to be actively involved in mentoring and guiding the business owners they invest in.
- Ideal for big growth plans: If you truly expect your business to be the next Uber/Facebook/Starbucks and have the business plan, financial projections, and other hard data to convince sophisticated investors you can do it, then it may be worth taking a shot at venture capital financing. You’ll need a strong management team, the ability to “sell” your concept, and a business plan that will generate a big return on the investors’ capital within a short time frame—typically three to five years.
Cons of Equity Financing
- You’ll have to give up control of your business: As you know by now, equity financing requires that you give up ownership in your business, and sometimes some control. This isn’t always the case: sometimes investors just want to invest, own a portion of the business, and not be involved in any decisions at all. However, some investors will want a lot of control over the future of the business. They do own some of it and stand to make some money of it doing well, after all.
- Not for short-term capital needs: Giving up equity in your business is a big decision, and you shouldn’t do it in return for financing that solves a short-term problem. If you are having a temporary cash crunch or need financing for the next year’s growth plans, look into a short-term financing solution that you can pay once you get “over the hump.
- Hard to acquire: Most investors are looking for the next Uber. They want to invest in a unicorn, or high-growth-potential businesses, so they’ll make a lot of gain on their investments. For that reason, equity financing makes the most sense for these high-potential startups. That’s not to say all investors are like this. You might have some luck working with industry-specific investors or using your network. However, when considering the debt vs. equity debate you need to consider the type of business you currently run and the type of business you want to run (not all business owners start a business to become the next Uber, for instance).
Debt vs. Equity: How to Decide Which Is Best for Your Business
The right solution for you when considering debt vs. equity financing may vary depending on your current needs and plans.
In general, taking on debt financing is almost always a better move than giving away equity in your business. By giving away equity, you are giving up some—possibly all—control of your company. You’re also complicating future decision-making by involving investors.
In contrast, taking on debt is a relatively short-term move that leaves you in control of the business, as long as you can pay back the debt and interest in full.