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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

Few businesses can survive without some form of financing. Even entrepreneurs who bootstrap their companies – that is, pay for it themselves – often rely on credit cards to get things going in the short term.

There is a variety of financing available out there, from bank loans and factoring services, to crowdfunding and venture capital. So, how can you know what to select?

There are two broad categories of financing available to businesses: debt and equity. Figuring out which avenue is right for your business can be confusing, and both comes with a set of pros and cons. Here's an introduction to each, what they mean, and important things to know before making your decision. [Learn about other alternative financing methods for startups in our guide.]

Many of us are familiar with loans, whether you've borrowed money for a mortgage or college. Debt financing a business is much the same. The borrower accepts funds from an outside source and promises to repay the principal plus interest, which represents the "cost" of the money you initially borrowed.

Borrowers will then make monthly payments toward both interest and principal, as well as put up some assets as collateral as reassurance to the lender. Collateral can include inventory, real estate, accounts receivable, insurance policies or equipment, which will be used as repayment in the event the borrower defaults on the loan.

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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Debt financing includes traditional loans from banks. The Small Business Administration (SBA) is a popular choice for many business owners. The SBA offers loans through banking partners 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 widely available in one form or another for most small business owners. It is a popular avenue for many businesses because the terms are often clear and finite, and owners retain full control of their operations unlike an equity financing arrangement.

However, the repayment and interest terms can be steep depending on the loan. Borrowers typically begin making payments the first month after the loan has funded, which can be challenging for a startup 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 means selling a stake in your company to investors that hope to share in the future profits of the business. There are several ways to obtain equity financing, such as through a deal with a venture capitalist or equity crowdfunding. Business owners who go this route won't have to repay money in regular installments or deal with steep interest rates. Instead, investors will be partial owners who are entitled to a portion of company profits and, perhaps, even a voting stake in company decisions depending on the terms of the sale.

Angel investors and venture capitalists are often on the lookout for startups with the potential to grow to great heights rapidly, if only they had the capital investment required to scale. These are often highly experienced, discerning investors who won't just throw money at any project. To convince an angel or VC to invest, entrepreneurs will need a pro forma with solid financials, some semblance of a working product or service, and a qualified management team. Angels and VCs can be difficult to contact if they're not already in your network, but incubator and accelerator programs have cropped up to coach startups on streamlining their operations and getting in front of investors.

Another version of equity financing, known as equity crowdfunding, allows businesses to sell very small shares of the company to many investors throughout their state. These campaigns usually require immense marketing efforts and a great deal of groundwork to hit the intended goal and become funded. The specifics of equity crowdfunding are laid out under Title III of the JOBS Act.

Unlike debt financing, equity financing is a lot harder to come by for most businesses. This type of funding is well suited for startups in high growth industries, such as the technology sector, and it requires a strong personal network, an attractive business plan, and the foundation to back it all up. However, companies that score investments will have capital on hand to scale up and will not be required to start paying it back (with interest) until the business is profitable.

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.

Business owners should be careful when selling shares of the company. If they relinquish more than 49 percent of the business, even to separate investors, they will lose their majority stake in the company. That means having less control over company operations and, potentially, risking removal from a management position if the other shareholders deem it prudent to change leadership.

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. Do some research on what is the norm in your industry, and what your competitors are doing. Investigate several financial products to see what suits your needs, and if you are considering selling equity, do so in a manner that is legal and allows you to retain control over your company.

Additional reporting by Elizabeth Peterson.

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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Adam C. Uzialko

Adam received his Bachelor's degree in Political Science and Journalism & Media Studies at Rutgers University. He worked for a local newspaper and freelanced for several publications after graduating college. He can be reached by email, or follow him on Twitter.