Equity financing vs debt financing: which is the best option for growing your business? One option might be more beneficial than the other, so make sure to learn everything you can about each before making a decision. Read on for our comprehensive guide on debt vs. equity financing.
Entrepreneurship isn’t easy. You’ll face a variety of challenges as you navigate through the ups and downs of running a business, but there’s one challenge that you’ll likely face more often than all the others: cash flow management.
Growing businesses find that this issue is prevalent. When you’re investing your profits back into your operation, you might find it difficult to afford your other expenses, such as payroll, rent, and keeping an emergency cash reserve.
You may also find it difficult to afford the growth opportunities that come your way, which, if you let them pass you by, can seriously hinder your growth and prevent you from reaching your true potential.
Entrepreneurs in any industry can secure additional funding in many ways. You can debt finance with a lender, or you can choose to go the equity financing route, which sacrifices a portion of your business to an investor in exchange for cash.
Both of these options can help you secure the money you need to grow, but is one option more beneficial than the other?
So, equity financing vs debt financing: which is better for your business? Continue reading for everything you need to know about either option and, more importantly, how to maximize your growth using each.
Equity financing vs debt financing: which one is better for your business?
1. What Is Debt Financing?
Debt financing refers to the concept of borrowing money (whether to secured or unsecured loans) to be repaid at a future date with interest. It is what most people think of when they hear “business loans”. In this type of financing, the lender doesn’t take equity in your business.
As the name suggests, debt financing is when you borrow money with an interest rate, paying back the amount within the term outlined by the third party who lent you the money.
Once you repay the borrowed amount, you have no obligations to the lender unless your contract dictates otherwise.
You can debt finance through multiple options, including term loans, business lines of credit, equipment financing, and many more. Each of these are characterized by different formats of how the funds are delivered to you, with options like term loans and SBA loans being given in one-time, lump sum payments.
Debt financing can allow you to secure the funding you need to grow, but only if you’ve signed on to a lender with favorable terms. You might feel obligated to accept a loan with terms that are outside of your organization’s capabilities because the opportunity in front of you is too good to pass up, but it’s a dangerous game.
An interest rate too high or repayment terms too short can force you to default on the loan, leaving your business in a worse financial spot than before.
The benefits of debt financing depends on the terms you’ve agreed to with your lender. The only way to get the best deal is to explore the options that are available to you, but this often requires you to set time aside to research lenders and their programs.
Rather than waste time you could have spent running your business, you can streamline your search for debt financing options with National Business Capital, the leading FinTech marketplace.
2. What Are The Different Types of Debt Financing?
Debt financing can take on a variety of formats. Here are a few of the most common debt financing options leveraged by entrepreneurs to support their growth:
2.1. Term Loans
A term loan is provided in a one-time, lump sum payment that you must repay within the terms outlined by your lender.
This financing option can be used for many different business purposes, but you may have to offer a detailed plan of how you intend to use the borrowed money to your lender before they approve you.
2.2. Business Line of Credit
Unlike a business credit card, a business line of credit allows you to draw physical cash at a moment’s notice. Most business lines of credit are revolving, meaning that when you repay the borrowed amount, you can draw the same funds again.
2.3. SBA Loans
The SBA offers business loan options with competitive rates to entrepreneurs who meet their eligibility criteria.
However, these criteria are very restrictive, and many businesses without strong financials might find it difficult to qualify. But, with interest rates so low and borrowing limits so high, it’s an option that any entrepreneur should explore.
2.4. Merchant Cash Advance
Merchant cash advances are an advance on your future payments. Basically, you sacrifice your future accounts receivable for cash in the short-term.
The amount you receive from your lender will be less than the actual value of your receivables because of the portion your lender takes as payment, but if you need cash fast, this could be an avenue toward growth.
3. What Is Equity Financing?
Equity financing refers to the concept of sacrificing a portion of your business to an investor in exchange for cash. Once the transaction is completed, the investor owns a part of your business and can collect a percentage of the future profits the business generates.
When discussing equity financing vs debt financing, it’s important to understand both concepts really well so we can contrast them.
The one key benefit of equity financing is that you won’t have to repay the investor the amount they gave to buy into your business. That is, of course, unless you’re buying them out of their stake.
You can equity finance through venture capitalists, angel investors, or equity crowdfunding platforms, including Fundable and MicroVentures. All three of these options require a degree of luck in their application, as you never know when someone will find your business and decide they want in.
Losing complete ownership of your business means a number of things. First of all, you’ll have to give the investor a percentage of your profits that corresponds to the portion of your business they purchased.
It can also depend on a pre-determined percentage of your profits. Still, if they invested substantial money into your business, you can expect them to want a significant amount of your profits as repayment.
The investor may also want a say in your business decisions after the investment. This can be a good opportunity or a bad one depending on the investor’s experience in your industry, but either way, equity financing can result in losing complete control over your business decisions.
4. What Is the Difference Between Equity Financing vs Debt Financing?
Put simply, the difference between equity financing vs debt financing is equity. In debt financing, the company borrows money directly, without giving up any ownership, while in equity financing, the company has to sell give a percentage of ownership stakes in exchange for financial backing.
When comparing equity financing vs debt financing to decide which one is better, it’s important to keep in mind that each option comes with its pros and cons. Both debt and equity financing can help you secure the funds you need to support your business as it grows.
Each option comes with unique advantages and drawbacks, so you should review the needs of your business and its capabilities to determine which option will be most beneficial for your specific situation.
Here are some pros and cons of equity financing vs debt financing:
4.1. Debt Financing
Pros
Faster funding, high borrowing limits, maintain complete control over your business, variety of financing options to choose from
Cons
Need to meet eligibility criteria of lenders, the requirement to repay the borrowed amount, interest rates make borrowing more expensive
4.2. Equity Financing
Pros
Debt-free funding, potential to gain an experienced industry professional in your corner, can secure high borrowing amounts depending on investor
Cons
Lose complete control over your business, difficult to find an investor, not necessarily beneficial for short-term needs
5. How Can I Decide Between Equity Financing vs Debt Financing?
Some businesses might benefit from equity financing, but others might not want to lose control over their business. It all depends on your goals and how you intend to operate your business in the future.
If you have a solid plan for the future that you want to stick to, it might not be a good idea to go down the equity financing route. The investor might want to make changes in your operation—good, bad, or indifferent—that you might not agree with.
But, if they’ve already invested in your business and have become a part-owner, they technically have a say in your operations, and you may have to follow their plan to keep everyone happy.
On the other hand, debt financing might not be the best option for an entrepreneur who has a newly started business or one that has poor financials.
Every lender is different, and some may have strict eligibility requirements that prevent your business from reaching approval. You’ll need to have a high credit score, a lengthy time in business, and generate substantial annual revenue to give yourself the best possible chance of securing the funds you need through debt financing.
If you can tolerate having another party involved in your business, then equity financing might be the better option for your business. However, this is only if you don’t need fast funding, as equity financing doesn’t happen at the speed of debt financing.
An entrepreneur that wants to maintain complete control over their operations should go down the debt financing route, even if their financial information is less than favorable.
Remember: The benefits of each financing option will depend on the needs of your business and the situation you’re in.
6. Streamline Your Search for Debt Financing Options With National Business Capital
National Business Capital, the leading FinTech marketplace, has secured $2 billion on behalf of entrepreneurs since 2007, saving them countless time and helping them accomplish their goals.
Our experienced team of Business Finance Advisors learns about you, your business, and your challenges to connect you with best-fit financing options within our 75+ lender marketplace.
We aim to establish a relationship with the entrepreneurs who trust us, so you can leverage our assistance for any future financing needs and continue to grow your business without restraint.
If you have questions during the process, you can be sure that our team will help you find the answers. Ready to get started? Complete our digital application to complete our application, and our team will be in touch with you shortly!
FAQs
Is It Better to Start Your Business With Equity or Debt Financing?
There isn’t necessarily a “one-size fits all” answer to debt vs. equity financing. Debt financing is generally the better option considering that equity financing often involves the business owner losing complete control over their operation, but some entrepreneurs might be comfortable with that contingency.
While it might be difficult to meet the eligibility requirements of lenders during the early stages of your business, it’s usually the better option, especially if you have a comprehensive plan on how you intend to operate your business in the future.
How Do You Choose Between Debt and Equity Financing?
Your first step is to evaluate the capabilities of your business and what your goals are. Many entrepreneurs will try to avoid equity financing at all costs because they don’t want to lose complete control over their business, but in some cases, it might be your only option.
Before you decide on equity financing, make sure to explore debt financing lenders thoroughly to ensure you’re not missing out on a deal that could help you grow your business.
Why Is Debt Financing Good for Businesses?
Debt financing is an opportunity to strengthen your business’s credit as you repay your financing.
Each timely payment will work for your score, increasing it ever so slightly in every instance. After your loan is completely paid off, your business credit score will likely be stronger depending on your payment history, which can help you secure additional capital in the future with ease.