The Difference Between Debt and Equity Financing for Your Small Business

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When it comes to funding a small business, there are two basic options: debt or equity financing.

Each has its advantages and drawbacks, so it’s important to know a bit about both so you can make the best decision for financing your business. 

Here, we’ll take a look at debt vs. equity financing and their respective pros and cons to help you make the best decision for your small business. Read on for a detailed overview, or use the links below to navigate throughout this post.

Debt Financing

Debt financing involves borrowing money, typically in the form of a loan from a bank or other financial institution or from commercial finance companies, to fund your business. Getting a business loan generally requires good credit and solid financials, as well as collateral for larger loans.

Business loans are a common form of financing, in fact, 43% of small businesses applied for a loan in 2020. Like any financial decision you’ll make for yourself or your small business, it’s important to consider several options to find the one that’s best suited for your goals.

Pros and cons of debt financing

Debt financing has some definite advantages that make it an option worth considering for any small business owner. 

  • Pro: First and foremost, unlike with equity financing, debt financing allows you to retain control of your business, as ownership stays fully in your hands.
  • Pro: You may have to back up a loan with collateral, so if you default you may lose certain tangible assets, but you won’t lose creative and strategic control of your business.
  • Pro: Taking on debt can build your business credit, which is good for future borrowing and for insurance rates.
  • Pro: It’s also worth bearing in mind that interest paid on loans is tax-deductible, softening the blow of repayment somewhat.

In addition to its advantages, debt financing also presents several drawbacks small business owners should take into consideration.

  • Con: Capital acquired through debt financing must be repaid. Many small business owners are afraid to take on debt because they fear they may not have the cash flow to repay the debt (plus interest) in a timely fashion.
  • Con: When you apply for a loan, lenders will consider your credit history to determine whether or not to approve your application. Some business owners may be concerned that they don’t have the credit-worthiness to get a bank loan, and so don’t want to even bother applying.

Types of debt financing

Now that we’ve covered the basics, let’s take a look at the different types of debt financing options out there.

Secured lines of credit

A secured line of credit can be used like a credit card, where you spend money as you need it and pay back the balance over time. The difference with a secured line of credit is that you’re required to back your line of credit with collateral, such as real estate or other liquid assets. 

Credit cards

Credit cards are likely the line of credit you’re most familiar with. You can open a credit card with a bank, credit union, or other type of credit lender and spend up to your credit limit. The money you borrow then has to be paid back with interest, according to the credit terms. 

Term loans

Term loans authorize the full amount of capital upfront, so you can spend it as you need and pay it back with a series of regular payments over a predetermined amount of time. 

Merchant cash advances

A cash advance from a merchant fronts cash from potential sales. This form of financing is usually accessible to businesses that have a steady volume of credit card transactions. Businesses receive a loan from a lender and then repay it to consumers while they make profits.

Invoice or receivables financing

Businesses that bill customers through invoicing can get funding by accessing accounts receivable (AR) income before it’s been paid. Through invoice financing, AR financing companies basically buy out your unpaid invoices for a percentage of the amount due. Your business can then use the capital and the AR financing company will collect the balance owed from your customer.

Equity Financing

Equity financing involves bringing in investors or partners who provide capital in exchange for a share of ownership of the business. These investors or partners generally invest because they expect to make a profit when the business becomes successful.

Pros and cons of equity financing

Like debt financing, there are several advantages and drawbacks of equity financing. Here are a few examples to consider when comparing debt vs. equity financing.

  • Pro: Unlike a loan, if you don’t make a profit, you usually aren’t required to pay investors back. The absence of monthly loan payments can free up significant working capital for the business.
  • Pro: 36% of small businesses that were denied at least some of the funding they requested were denied because of their credit score. One of the advantages of equity financing is that it can be more accessible for those that don’t have a strong credit history. Many small business owners are drawn to equity financing because, while investors or partners will only provide equity if they have faith in the earning power of your business, you don’t necessarily need the pristine financial history that is required for a loan.

  • Con: With equity financing, you no longer retain sole control of your business. This means that not only will your investors be entitled to a share of profits, but they also have a say in the running of your business and the direction it’s headed. This may not seem like a problem at the beginning when you need cash but can sometimes lead to conflict further down the road.
  • Pro: On the other hand, a strong, smart partner may be an asset to your business; especially if you find someone who is a good compliment to yourself. For example, if you’re the creative, visionary type, you may benefit from the balancing influence of a partner who is grounded and pennywise.

Types of equity financing

Let’s take a look at a few ways your business can approach equity financing if it’s the right fit for you:

Friends and family

If you’ve got a strong network of family and friends that really believe in your business, you may be able to form a partnership with them in order to access financing. Traditionally, these private investors will request a percentage of ownership in exchange for their capital investment.

Angel investors

Angel investors are usually individuals or part of investment associations. They typically have a lot of funding to offer and often look for larger ownership roles.

Venture capital firms

Venture capital firms are public associations that focus their funding on highly auspicious businesses for a portion of ownership.

The Bottom Line 

Because each type of financing has its own appeal, businesses often take advantage of both debt and equity financing, utilizing each to its best advantage.

Look at the benefits of each to see which may most help your business, and compare typical debt-to-equity ratios for other businesses in your industry when deciding what type of financing to seek.

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