Debt financing vs.
Business owners must choose between two sources of financing: debt financing or equity financing. Their choice will have a huge impact on how their business operates. The right choice will help it grow, while the wrong will indebt it.
We will start by elaborating more on these two types of financing and their different options. Next, we’ll compare debt versus equity by exploring their pros and cons. Most importantly, we will explain why it is better to choose a mixture of the two.
The right financing options can help a startup raise capital and get started. Meanwhile, a long-standing business can use it to improve and soar. Understanding the differences between debt financing and equity financing can help create a healthy ratio for your business.
What is debt financing?
The first type works like credit cards and other debt securities. You borrow a sum of money or regular payments. They give you money now and then you have to pay them back later.
The business loan has a principal and an interest rate. When you pay off a lender, they earn money from your interest payments. Sounds pretty straightforward, right?
People can borrow money from a variety of sources, and so can businesses. Let’s look at it different sources of debt financing below:
- Commercial loans – This is one of the easiest options. You can get them through lines of credit or government programs. The latter, however, may offer better benefits to small businesses. For example, the SBA Increased COVID Loan Amounts and improved the conditions of forgiveness.
- Installment purchases – This is when you borrow money to get the things you need for your business. This could be taking out a mortgage for a new office branch or auto loans for its vehicles. This is only an option if you have a good credit rating.
- Revolving credit – This is when you use a credit card to buy smaller things for your business, like office supplies. It’s a great way for small businesses to build credit. Use your card to buy a few things, then pay on time to increase your score.
- Commercial credit – These are the “buy now, pay later” agreements that you make with the supplies. For example, a ghost kitchen can get ingredients now, then refund within 30 days.
- Obligations – Think of them as “IOUs (I owe you.)”. A business owner asks for a certain amount and then someone else can provide it. The owner pays the lender back, and he earns more money. Investors see bonds as relatively low risk assets which can provide a fixed income.
What is equity financing?
Now let’s move on to the other type of business financing. Equity financing comes from stocks and you sell part of the ownership of your business to raise funds from investors.
The main difference between debt financing and equity financing is the ownership of the business. With debt financing, you are in full control. Lenders cannot stop you in your business decisions.
On the other hand, equity financing allows investors to own a portion of your business. It means they have a say in how your business operates. We will talk about this later.
As with debt financing, you can get equity financing from various sources. The choices available will also depend on your current situation. Let’s take a closer look at each:
- Family and friends – If you have a startup, close friends and relatives could be your first source of capital. Be careful when you sell shares of your business. This can complicate your relationship with these people.
- angel investors – These are wealthy people who invest around $ 2 million in startups with growth potential. If you have watched Shark aquarium, you saw them in action!
- Crowdfunding – This is when you ask the public for money and give them equity in return. Your payment can also be a good or a service.
- Venture capitalist – They are similar to angel investors, but they only invest in operating companies.
- Public float – It is a question of issuing securities like shares to the public. First, a company must issue an initial public offering (IPO). Then it’s publicly traded, and that’s where it could build up a float with retail investors.
Advantages of debt over equity financing
Now that you are familiar with both types of financing, let’s talk about their benefits. We’ll start with debt financing, and unlike equity financing, you will have full control of the funds.
As a business owner, no one decides how to spend the money. Your lenders can, however, give you suggestions. Yet they cannot stop any of your trading decisions.
In addition, interest payments are tax deductible. If you have good credit, you can easily borrow more money. You can also schedule your loan payments to match your cash flow.
In contrast, equity financing offers another freedom. Equity instruments don’t tie you to any debt obligation, and in return, you don’t have to set aside profits for debt repayment.
In addition, your equity investors could help you run your business. They also need your business to be successful, and if it doesn’t, their inventory will plummet. They could become great business partners.
Read more: What is corporate debt?
Disadvantages of Debt Versus Equity Financing
After talking about their good sides, let’s talk more about their flaws. We’re going to start over with debt financing, and its main downside to equity is that it reduces your available funds.
You will need to set aside a portion of your profits to pay off your debts. This leaves you with less money to spend on improving your business, and you have more problems if you have too much debt.
Excessive business debt can discourage potential investors, and they will view your business as “high risk,” which means you are less likely to repay your debts. After all, you still have a lot of debt!
Depending on your loan, your business assets may be held as collateral. If you don’t pay it back for too long, your lenders may take these items away from you. Of course, equity financing also poses problems.
The main problem is selling part of your business to other people. They also become owners, so you cannot exclude them from your business decisions.
You can see why this is an important decision. Is reducing control of your business worth it? As we said, they could help plan its growth.
Unfortunately, sometimes you may have to argue with them. It could delay your plans. In addition, you will have to return part of your profits to your shareholders.
In addition, raising capital from equity takes a lot of money and time. This is why some companies are finding alternatives. For example, Coinbase chose a direct listing instead of an IPO.
What is the best choice ?
Have you chosen a camp between debt financing and equity financing? Well the ideal way is to have a mix of the two options. In other words, you should have a good debt ratio.
You get this by dividing your total debt and equity. You might think that having a high count is a good thing, and after all, you get it if you have a lot less debt than stocks.
However, a high ratio could indicate to investors that you are having difficulty paying debtors. They might think your business is in trouble with money.
On the other hand, a weak rate of endettement could mean that your business depends on too much equity. Investors see it as an inefficient way of financing businesses.
We just talked about the benefits and costs of debt and equity financing. As the owner, you have the final say in how you get funds for your business.
Be sure to explore all the options available. The internet can help you do this for free, and there are countless blogs and videos that offer advice.
Fortunately, you can get started right now by checking out other articles from Inquirer USA. Read more business tips, as well as other investing topics.
Learn more about the difference between debt and equity
How is debt different from equity?
Debt financing provides capital from loans and other lines of credit. On the other hand, equity financing comes from the sale of shares. The former gives you full control over how to spend the borrowed money. In the meantime, the latter does not take any amount from your winnings.
Is equity better than debt?
A healthy business must have a mix of debt and equity for its capital structure. This allows for a stable source of funds while attracting new investors. However, this mixture will depend on many factors. Balance the benefits and costs of debt and equity to get the right ratio.
What does a debt-to-equity ratio tell you?
It tells you how much debt a business has in relation to its equity. If he has too much, it could mean he’s struggling to repay lenders. If the ratio is too low, the company may be too dependent on stocks. Of course, you have to look at other factors to determine the health of a business.