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Start Your Business Startup Funding

Debt vs. Equity Financing: What's the Best Choice for Your Business?

Debt vs. Equity Financing: What's the Best Choice for Your Business?
Credit: Rawpixel/Shutterstock

Finding ways to fund your business is often a major concern for entrepreneurs. While there are many types of financing, don't settle for just anything.

If you are looking to open a business or expand your current operation, there are two main financing options: debt financing or equity financing. Deciding which one is right for your business can be confusing. Below we've outlined each option, including the pros and cons of each method. [Alternative Financing Methods for Startups]

Debt financing is borrowing funds from an outside source with the commitment to repay, plus interest. This encompasses traditional loans, such as those offered by banks. Borrowers make payments monthly and offer a form of collateral, such as inventory, real estate, accounts receivable, insurance policies or equipment, which can be used to repay the loan if the borrower defaults on the loan.

The Small Business Administration (SBA) is a popular choice for business owners. The SBA offers loans with lower interest rates and longer terms, but there are stricter requirements for approval.

Alternatives to business loans include merchant cash advances, personal lines of credit and business credit cards. With some of the alternative financing methods, borrowers may be required to make weekly payments or repay a percentage of their profits rather than make fixed monthly payments.

Debt financing is available in some form for most small business owners. It is most popular with traditional business, such as those companies in the  manufacturing or retail sectors. With traditional debt financing, borrowers retain complete control of their business, and they have a finite agreement with their lender.

However, the repayment and interest terms can be steep. Borrowers typically begin making payments the first month after the loan has funded, which can be challenging, because the business isn't on firm financial footing yet.

Another disadvantage of debt financing is the potential for personal financial losses if it becomes impossible to repay the loan. Whether a business owner is risking their personal credit score, personal property, or previous investments in their business, it can be devastating to default on a loan.

Equity financing involves funding business aspirations by selling individual shares of the company to investors. Business owners who choose this method don't have to repay the money with regular installments. Instead, those individuals who purchased shares of the company become partial owners who are entitled to a portion of the profits for as long as they hold those shares.

One of the most common arrangements has investors waiting to be repaid until the business is earning a predefined profit. Payments then continue until investors have been repaid and received the agreed-upon profit.

In other situations, investors may retain their shares unless they are sold. Usually, smaller businesses approach friends and family to invest, but angel investors and venture capitalists may invest in a business.

Equity financing isn't as readily available for business owners. This type of funding is well suited for startups in the innovation or technology sectors; it requires a strong personal network or an appealing business plan. However, it doesn't put constraints on cash flow and isn't as financially risky as other options.

Equity financing allows the business owner to distribute the financial risk among a larger group of people. When you aren't making a profit, you don't have to make repayments. And if the business fails, none of the money needs to be repaid.

One of the most significant disadvantages of equity financing is the loss of control business owners face when they work with several investors. It's possible to lose substantial control if the shares owned by investors equals more than 49 percent.

Ultimately, the decision between whether debt or equity financing is best depends on the type of business you have and whether the advantages outweigh the risks.

Editor’s Note: Considering a small business loan? If you’re looking for information to help you choose the one that’s right for you, use the questionnaire below to get information from a variety of vendors for free:

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Elizabeth Peterson

Elizabeth writes about innovative technologies and business trends. She has traveled throughout the Americas in her roles as student, English teacher, Spanish language interpreter and freelance writer. She graduated with a B.A. in International Affairs from the George Washington University. You can follow her on Twitter @techEpalermo or .