Difference between equity financing and debt financing
All forms of external financing are generally classified into one of two types: debt financing or equity financing. These are two distinct business financing options and each has their respective advantages and disadvantages. Many companies prefer to use a combination of the two methods. In this article, we explore the terms “debt and equity” and look at some of the key differences to help you make the best financial decision when raising money for your business.
What is equity financing?
Equity financing is the process of raising money by selling stakes or shares in your business. There are different types of equity financing, some of which include private equity firms, angel investors, venture capital firms, and crowdfunding platforms. Some companies may choose to raise multiple rounds of equity financing from various types of investors throughout the life cycle of the business.
Equity investors then profit from their investment by receiving dividends (a portion of the organization’s profits – which is more typical for mature companies) or possibly selling their shares. Equity investors generally have a keen interest in growing the business, and having the right investors will provide the valuable contacts and expertise the business needs to grow.
What is debt financing?
Whether you’ve ever taken out a car, student, or mortgage loan, chances are you are already familiar with debt financing. Basically, it’s about borrowing a huge amount, which the company then pays back over time, in addition to an interest rate that has been agreed upon.
There are various forms of debt financing, including business loans, asset finance, commercial mortgages, and working capital facilities, such as bill discounting and overdrafts. A loan can be secured by personal property or unsecured. Due to the reduced level of risk for lenders, secured debt is generally cheaper and easier to obtain.
Here is the difference between equity financing and debt financing
There are some key differences you should be aware of before deciding which of these two financing options to choose.
Debt financing requires that you repay the loan plus an agreed interest over a specified period of time, usually in monthly installments. On the other hand, equity financing does not impose any repayment obligations, which means you have more funds than you can spend on expanding your business.
Of course, investors look forward to making great returns on their investment, however, this can only be achieved if and when your business is doing well in the industry. So unlike debt financing which has a predetermined cost, equity financing has a more variable cost because it is a stake in the future value and profits of your business.
When equity investors buy a share of your company, your own shareholding decreases, but with debt financing, you keep 100% ownership. Nonetheless, it may be worth considering a decrease in company ownership if your equity investor is willing to invest a lot of resources (which can be both monetary and non-monetary, such as access to contacts and expert advice) that helps you build a bigger, more successful business.
In debt financing, a lender can ask the borrower for collateral as collateral for the loan, such as equipment or property. If the borrower is unable to repay the loan, we all know what’s going on – the lender would claim the asset as payment for their money. However, with equity financing, you are not required to provide any form of collateral.
Access to financing
Start-ups without physical assets or a business history, and unwilling to use personal security, might find it difficult to obtain debt financing, especially from traditional lenders. On the other hand, equity investors tend to invest in companies considered extremely risky by many debt finance providers.
Most equity investors might demand a seat on the board. This means that they will have a contribution to the general management of the company and will be actively involved in the decisions of the company. It can be a blessing for the business if you have the right investor (s) who will add valuable expertise and experience to the board and also be willing to lead the way for you with their network of contacts. A lender, on the other hand, has no property and is therefore not involved in the decisions of the business.
Equity financing may not be the best option for you if you are in a rush to raise capital for your business. Finding the right investor can take a considerable amount of time, after which you need to discuss the terms of the transaction and organize the necessary due diligence process, among other niceties. A lot of legal work is also involved. Debt financing, however, tends to be simpler, as you can even get the funds in as little as a few weeks or maybe a few days from some lenders.
Which is right for you: debt financing or equity financing?
Ultimately, the financing option you choose will be determined by your individual needs, including the nature of your business as well as its stage of development.
You may want to consider debt financing if:
- Your cash flow is consistent and you have a proven business model
- You want to keep exclusive ownership of your business
- You prefer a short-term relationship that ends as soon as the loan is repaid
- You have an easier time managing your cash flow and forecasting your expenses as long as you know in advance the principal and interest you have to pay
And you should consider equity financing if:
- Your business has a limited financial history or no collateral
- You don’t like the idea of regular loan payments
- You have certain plans for growth, such as expanding operations or migrating to new markets, which will cost a huge amount of capital (equity financing usually allows you to raise higher amounts)
- You want to benefit from the experience and skills that an investor has to offer