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Start Your Business Startup Funding

The Difference Between Debt and Equity Financing

image for Chainarong Prasertthai / Getty Images
Chainarong Prasertthai / Getty Images
  • Debt and equity financing are two very different ways of financing your business.
  • Debt involves borrowing money directly, whereas equity means selling a stake in your company in the hopes of securing financial backing.
  • Both have pros and cons, and many businesses choose to use a combination of the two financing solutions.

Unless you're Kylie Jenner and have an existing empire of wealth to build on, chances are good that you'll need some sort of financing in order to start a business. Even entrepreneurs who bootstrap their companies often need credit cards to get things going.

There are many financing options for small businesses, including bank loans, alternative loans, factoring services, crowdfunding and venture capital. With this selection, it can be difficult to determine which option is right for you and your business.

The first thing to know is that 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 each option has its own set of pros and cons.

Here's an introduction to both debt and equity financing, 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 for college tuition. 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, and put up some assets for 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: 

Debt financing includes traditional loans from banks. The Small Business Administration is a popular choice for 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 businesses because the terms are often clear and finite, and owners retain full control of their operations, unlike in an equity financing arrangement.

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 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 and may result in bankruptcy.

Equity financing means selling a stake in your company to investors who hope to share in the future profits of your 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 in regular installments or deal with steep interest rates. Instead, investors will be partial owners who are entitled to a portion of company profits, perhaps even a voting stake in company decisions depending on the terms of the sale.

Angel investors and venture capitalists are two types of equity investors that are often on the lookout for startups with the potential to grow rapidly but require a capital investment to do so. These are often highly experienced, discerning investors who won't throw money at just any project. Angel investors are high net worth individuals who often have some sort of relationship with the business founder, while venture capitalists are seasoned private investors who seek out promising startups.

To convince an angel or VC to invest, entrepreneurs 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 often coach startups on how to streamline their operations and get in front of investors, and they may have internal networks to draw from.

Another version of equity financing, known as equity crowdfunding, allows businesses to sell very small shares of the company to many investors via crowdfunding platforms. These campaigns usually require immense marketing efforts and a great deal of groundwork to hit the intended goal and be funded. Title III of the JOBS Act lays out the specifics of equity crowdfunding.

Unlike debt financing, equity financing is hard 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 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. If the business fails, none of the money needs to be repaid.

Business owners should, however, be careful when selling shares of the company. If you relinquish more than 49% of your business, even to separate investors, you will lose your majority stake in the company. That means less control over company operations and the risk of removal from a management position if the other shareholders decide to change leadership.

"It's true that equity often doesn't require any interest payments like in the case of debt," said Andy Panko, owner and financial planner at Tenon Financial. "[But] the 'cost' of equity is typically higher than the cost of debt. Equity holders will still want to get compensated somehow, [which] generally means having to pay dividends and/or ensuring favorable equity price appreciation, which can be difficult to achieve."

Ultimately, the decision between debt and equity financing depends on the type of business you have and whether the advantages outweigh the risks. Do some research on the norms in your industry and what your competitors are doing. Investigate several financial products to see what suits your needs. If you are considering selling equity, do so in a manner that is legal and allows you to retain control over your company.

Many companies use a mix of both types of financing, in which case you can use a formula called the weighted average cost of capital, or WACC, to compare capital structures. The WACC multiplies the percentage costs of debt and equity under a given proposed financing plan by the weight equal to the proportion of total capital represented by each capital type.

Adam C. Uzialko and Elizabeth Peterson contributed to the reporting and writing in this article.

Kiely Kuligowski

Kiely is a staff writer based in New York City. She worked as a marketing copywriter after graduating with her bachelor’s in English from Miami University (OH) and is now embracing her hipster side as a new resident of Brooklyn. You can reach her on Twitter or by email.