Debt vs. Equity financing – Which is best for your business?
Business owners have to choose between two sources of funding: debt vs. equity financing. Their pick will have a huge impact on how their company runs. The right choice will help it grow, while the wrong one will pin it down with debt.
We will start by elaborating more about these two types of financing and their various options. Then, we will compare debt vs. equity by exploring their pros and cons. More importantly, we will explain why it’s better to choose a mix of both.
The right financing options can help a startup raise capital and get off the ground. Meanwhile, a long-standing business can use it to improve and soar higher. Understanding the differences between debt vs. equity financing can help in creating a healthy ratio for your company.
What is debt financing?
The first type works like credit cards and other debt instruments. You borrow a sum of money or regular payments. They give you money now, then you have to pay them back later.
The business loan has a principal and interest rate. When you repay a lender, it earns money through your interest payments. It seems simple enough, right?
People may borrow money from various sources, and the same is true for businesses. Let’s look at the different sources of debt financing below:
- Business loans – This is one of the simplest options. You may get these from lines of credit or government programs. The latter may provide better benefits for small businesses, though. For example, the SBA increased its COVID loan amounts and improved the forgiveness terms.
- Installment purchases – This is when you borrow money to get stuff you need for your business. These may include 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 score.
- Revolving credit – This is when you use a credit card to buy smaller things for your business, such as office supplies. This is a great way for small businesses to build credit. Use your card to buy a few things, then pay on time to raise your score.
- Trade credit – These are the “buy now, pay later” agreements you make with supplies. For example, a ghost kitchen may get ingredients now, then repay within 30 days.
- Bonds – Think of these as “IOUs (I owe you.).” A business owner asks for a certain amount, and then another person may provide it. The owner repays the lender, and it earns more money. Investors see bonds as relatively low-risk assets that may provide fixed income.
What is equity financing?
Now, let’s turn to the other type of business financing. Equity funding comes from stocks, and you sell part ownership of your company to raise money from investors.
The main difference between debt vs. equity financing is the company ownership. With debt financing, you’re in full control. Lenders can’t stop you in your business decisions.
On the other hand, equity financing allows investors to own a bit of your company. This means they get a say in how your business runs. We’ll talk more about this later.
Similar to debt financing, you may get equity funding from various sources. The available choices will also depend on your current situation. Let’s take a closer look at each one:
- Family and friends – If you have a startup, close buddies and relatives might be your first source of capital. Be careful when selling shares of your company. It may complicate your relationship with these people.
- Angel investors – They are wealthy people who invest around $2 million into startups with growth potential. If you’ve watched Shark Tank, you’ve seen them in action!
- Crowdfunding – This is when you ask for money from the public and give them equity in return. Your payment may also be a good or service.
- Venture capitalists – They’re similar to angel investors, but they only invest in operating companies.
- Public float – This involves issuing securities like shares to the public. First, a company must issue an initial public offering (IPO). Then, it gets listed on a stock exchange, and this is where it could accumulate a public float from retail investors.
Upsides of debt vs. equity financing
Now that you’re clear about both types of financing let’s talk about their advantages. We’ll start with debt financing, and unlike equity funding, you get full control of the funds.
As a business owner, no one gets to decide how to spend the money. Your lenders may give suggestions, though. Still, they can’t stop any of your business decisions.
What’s more, interest payments are tax-deductible. If you have good credit, you may easily borrow more money. You can also schedule your loan payments to adapt your cash flow.
On the other hand, equity financing offers a different kind of freedom. Equity instruments do not bind you to any debt obligations, and in turn, you don’t have to set aside profits for debt repayments.
Moreover, your equity investors could help you run your business. They need your business to succeed too, and if it doesn’t, their stocks will tank. They could become great business partners.
Read More: What Is Corporate Debt?
Downsides of debt vs. equity financing
After talking about their good sides, let’s talk more about their flaws. We’ll start with debt financing again, and its main disadvantage to equity is that it reduces your available funds.
You will have to set aside some of your profits for debt payments. This leaves you less money to spend on business improvements, and you get more problems if you have too much debt.
Excessive corporate debt may turn off potential investors, and they’ll see your company as “high risk,” meaning you’re less likely to repay debts. After all, you are still dealing with a lot of debt!
Depending on your loan, your company assets could be held as collateral. If you fail to repay for too long, your lenders can take away those items. Of course, equity funding also has issues.
The main problem is in selling a part of your company to other people. They also become owners, so you can’t leave them out of your business decisions.
You can see why this is a major decision. Is reducing the control of your business worth it? As we said, they could help in planning its growth.
Sadly, you may have to argue with them sometimes. This could delay your plans. What’s more, you will have to give parts of your profits to your shareholders.
Moreover, raising capital from equity takes a lot of money and time. That’s why some companies find alternatives. For example, Coinbase chose a direct listing instead of an IPO.
Which is the best choice?
Have you picked a side between debt vs equity financing? Well, the ideal way is to have a mix of both options. In other words, you should have a healthy debt-to-equity ratio.
You get this by dividing the total of your debts and your equity. You may think having a high number is good, and after all, you get that if you have far fewer debts than equities.
However, a high ratio could tell investors that you’re having trouble paying debtors. They might think your company is having trouble with money.
On the other hand, a low debt-to-equity ratio could mean your business relies on too much equity. Investors see this as an inefficient way of business funding.
We just talked about the benefits and costs of debt and equity financing. As the owner, you have the final word on how you’ll get funds for your business.
Make sure to explore all the options available. The internet can help you do that for free, and it has countless blogs and videos that offer advice.
Fortunately, you can start now by checking other articles from Inquirer USA. Read more business tips, as well as other investment topics.
Learn more about the difference between debt vs. equity
How is debt different from equity?
Debt financing provides capital from loans and other lines of credit. On the other hand, equity funding comes from selling shares. The former gives you full control over how to spend borrowed money. Meanwhile, the latter doesn’t take any amount from your earnings.
Is equity better than debt?
A healthy company should have a mix of debt and equity for its capital structure. This allows a steady source of funds while still drawing in new investors. However, this mix will depend on numerous factors. Balance the benefits and costs of debt and equity to get the right ratio.
What does a debt/equity ratio tell you?
It tells you how much debt a company has compared to its equity. If it has too much, this could mean it’s having a hard time paying back lenders. If the ratio is too low, the company might be depending too much on equities. Of course, you have to look at other factors to determine a company’s health.