Here's how to determine if you should accept debt or share ownership of your business.
- 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.
- This article is for small business owners who are trying to decide if debt or equity financing is right for them.
Unless you 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. 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 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.]
What is debt financing?
Many of us are familiar with loans, whether we've borrowed money for a mortgage or 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.
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Types of debt financing
The following types of debt financing are the most common:
- Traditional bank loans. While often difficult to obtain, these loans generally have more favorable interest rates than loans from alternative lenders.
- SBA loans. The federal 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.
- Merchant cash advances. This form of debt financing is a loan from an alternative lender that is repaid from a portion of your credit and debit card sales. Note that merchant cash advances have notoriously high annual percentage rates (APRs).
- Lines of credit. Business lines of credit provide you a lump sum of money, but you only draw on that money when you need some of it. You only pay interest on what you use, and you're unlikely to encounter the collateral requirements of other debt financing types.
- Business credit cards. Business credit cards work just like your personal credit cards, but they may have features that serve businesses better – such as spending rewards that business credit lines lack.
Key takeaway: Debt financing is when you borrow money and repay it with interest. Common types of debt financing include traditional bank loans, SBA loans, merchant cash advances and lines of credit.
Pros and cons of debt financing
Like all types of financing, debt financing has both pros and cons. Here are some of the pros:
- Clear and finite terms. With debt financing, you'll know exactly what you owe, when you owe it and how long you have to repay your loan. Your payment amounts will not fluctuate month to month.
- No lender involvement in company operations. Even though debt financers will become intimately familiar with your business operations during your approval process, they'll have no control over your day-to-day operations.
- Tax-deductible interest payments. When it comes time to pay taxes, you can deduct debt financing interest payments from your taxable income to save money.
These are some downsides of debt financing:
- Repayment and interest fees. These costs can be steep.
- Quick start of repayments. You'll typically begin making payments the first month after the loan has been funded, which can be challenging for a startup because the business doesn't have firm financial footing yet.
- Potential for personal financial losses. Debt financing comes with the potential for personal financial loss if it becomes impossible for your business to repay the loan. Whether you are risking your personal credit score, personal property or previous investments in your business, it can be devastating to default on a loan and may result in bankruptcy.
Key takeaway: The positives of debt financing are that all the terms are clearly spelled out, the lender isn't involved in how your company operates, and interest payments are tax deductible. The negatives are that interest fees can be steep, you have to start making repayment quickly, and defaulting could have significant consequences for your personal finances.
What is equity financing?
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.
Types of equity financing
These are some common types of equity financing:
Angel investors. An angel investor is a wealthy individual who gives a business a large cash infusion. The angel investor gets equity – a share in the company – or convertible debt for their money.
Venture capitalists. A venture capitalist is an entity, whether a group or an individual, that invests money into companies, usually high-risk startups. In most cases, the startup's growth potential offsets the investor's risk. In the long run, the venture capitalist may look to buy the company or, if it's public, a substantial portion of its shares.
- Equity crowdfunding. Equity crowdfunding is when you sell small shares of the company to numerous investors via crowdfunding platforms. These campaigns usually require immense marketing efforts and a great deal of groundwork to hit the goal and get funding. Title III of the JOBS Act lays out the specifics of equity crowdfunding.
Angel investors and venture capitalists are often highly experienced, discerning investors who won't throw money at just any project. 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.
"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."
Key takeaway: Equity financing is when you receive funding in exchange for shares in your business. Angel investors, venture capitalists and crowdfunding are common types of equity financing.
Pros and cons of equity financing
Similar to debt financing, there are both advantages and disadvantages to using equity financing to raise capital. These are some of the positives:
- Well suited for startups in high-growth industries. Especially in the case of venture capitalists, a business that's primed for rapid growth is an ideal candidate for equity financing.
- Rapid scaling. With the amount of capital a company can obtain through equity financing, rapid upscaling is far easier to achieve.
- No repayment until the company is profitable. Whereas debt financing requires repayment no matter your business situation, angel investors and venture capitalists wait until you make a profit before recouping their investment. If your company fails, you never need to repay your equity financing, whereas debt financing will still require repayment.
These are the main cons of equity financing:
- Hard to obtain. Unlike debt financing, equity financing is hard to obtain for most businesses. It requires a strong personal network, an attractive business plan and the foundation to back it all up.
- Investor involvement in company operations. Since your equity financers invest their own money into your company, they get a seat at your table for all operations. If you relinquish more than 50% of your business – whether to separate investors or just one – you will lose your majority stake in the company. That means less control over how your company is run and the risk of removal from a management position if the other shareholders decide to change leadership.
Key takeaway: The benefits of equity financing are that it allows for quick scaling and doesn't hurt your cash flow, because you don't have to repay the debt until the company becomes profitable. Potential downsides are that it's hard to obtain and the investors get a say in how the company is run.
How to choose between debt and equity financing
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.
Key takeaway: One way to determine which financing route is best for your business is to use the WACC formula, which allows you to compare capital structures.
Max Freedman, Adam C. Uzialko and Elizabeth Peterson contributed to the writing and research in this article.