Equity vs. Debt: Definitions, Types, Pros and Cons

Business owners often need additional financial resources to expand their companies by adding products, opening more stores or hiring more employees. With the right amount of money, they can buy new equipment, rent office space or grow their team. Two options include equity financing and debt financing. In this article, we describe what equity financing and debt financing are, compare the two and share the potential advantages and disadvantages of each one.

Key takeaways

• Debt and equity financing—or a combination of the two—are different ways to finance business growth and expenses.

• Equity financing means selling interest in your company in exchange for capital.

• Debt financing means borrowing money from a lender or investor and paying it back with interest.

What is equity financing?

Equity financing means raising money by selling interests in the company to an investor in exchange for capital to help you grow your business.

For example, you create and distribute T-shirts. Next, you, need money to buy a warehouse to store inventory and use for packaging. You sell 5% interest in your company to an investor willing to provide the capital the company needs to expand its operations. The investor now owns 5% of the company and can weigh in on important business decisions.

Types of equity financing

If you want to raise money for business growth, it’s important to know the different types of equity financing available to you. They include:

• Initial public offering (IPO): An IPO is when your company goes public on the New York Stock Exchange (NYSE) and investors can purchase shares in your company.

• Angel investors: An angel investor is someone who wants to help startups get the money they need to create and build their businesses. They usually seek out businesses they feel will provide a large return on their investments. Angel investors receive equity in the company in exchange for their capital investment and the knowledge they bring to the business.

• Venture capital: You may secure venture capital from a firm made up of investors who combine their money to invest in startups or small businesses.

• Equity crowdfunding: Equity crowdfunding is when you solicit money from your target audience in exchange for equity or a promise of goods or services, once your business reaches its financing goal.

What is debt financing?

Debt financing refers to borrowing money that you will pay back with interest. A company can obtain debt financing through a bank or an investor.

Types of debt financing

There are many types of debt financing available to business owners. They include:

• Personal loans: If you must use your own assets or if your company is brand new, you may need to secure a personal loan to get started.

• Small Business Administration (SBA) loans: You can also secure financing with this federal agency dedicated to assisting small business owners with the financing and resources they need to make their businesses succeed. Although the SBA doesn’t directly provide loans to business owners, they do have many loan programs available in collaboration with lenders.

• Line of credit: A line of credit is when you have direct access to certain funds that you can use when needed. Your lender will set a cap on the amount available and you only pay interest on the money you use.

• Credit cards: Just like personal credit cards, you can apply for and receive a business credit card. These credit cards are also subject to some of the same terms as personal credit cards including repayment schedule and interest rate.

• Conventional loans: With conventional loans, you usually receive the lump sum of money you need and you pay back the money with interest in a predetermined amount of time.

• Cash flow loans: This is another type of debt financing that involves you receiving a certain amount of money based on your current revenue.

Example of equity vs. debt financing

You own a bicycle company and want to secure a factory where you can put bikes together more quickly to meet the increasing demand for your bikes and accessories. You’ll also need to hire employees to work in the factory and buy more equipment to maintain operations.

To do this, you need $10 million in capital. To raise the money you need, you can either choose equity financing, debt financing or a combination of the two.

With equity financing, you might approach an investor for $10 million in capital in exchange for a 20% equity in your business. This investor would own 20% of your company and make business decisions alongside you and other owners. All would benefit from the company’s future success.

With debt financing, you might approach a bank and take out a $10 million loan with a 2% interest rate that you must pay back within five years.

Another choice is to combine the two types of financing. You might ask an investor for $5 million in exchange for 10% ownership in your company. You then borrow $5 million from a lender to be paid back with interest in three years.

How to choose between equity and debt financing

When you consider financing to expand your business, it’s crucial to think about your unique situation. Take into account your current cash flow and which financing options are easier for you to obtain. You’ll also need to decide how important it is to retain ownership in your company.

If you are the only owner, you must decide if you are OK with an investor becoming your business partner. If there are other owners in the business, everyone should agree to sell ownership equity to an investor.

Advantages and disadvantages of equity and debt financing options

Learn more about the pros and cons of each type of financing option:

Equity financing advantages and disadvantages

The advantages of using equity financing include:

• You don’t repay the money the investor provided. Because you sold a portion of your company shares, it was an even exchange of capital and equity.
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• Equity financing isn’t financially burdensome. Because you don’t pay investors or cover interest charges, your company doesn’t take on any additional debt.

• You can immediately grow your business. With equity financing, you have no monthly repayments. This frees up available capital to best fit your company’s growth.

The potential disadvantages of using equity financing include:

• You sell a portion of your company. This can be difficult for many small business owners to do, especially if the company isn’t yet generating a profit.

• Others have a say in running the company. Investors with a percentage share of ownership have a say in important business decisions.

• It can be expensive to buy investors out. If your business is doing well and you want to buy ownership back from the investor, it will likely cost you more money than what the investor originally provided as capital.

Debt financing advantages and disadvantages

The advantages of using debt financing include:

• You retain control over your business. No matter who the lender is, they will not own any portion of your business. You are only in a relationship with the lender for the duration of the loan period.

• There is no claim on future profits. The lender is entitled only to the repayment of the agreed-upon principal of the loan plus interest. You do not have to be concerned about giving up profits to a shareholder as you would in equity financing.

• Your interest is tax-deductible. You can claim your interest payments on your business taxes which makes the total cost of your loan less.

• It’s less complicated. Debt financing is less complicated because your company is not required to comply with state and federal securities laws and regulations. You also don’t have to send out financial information to investors, conduct shareholder meetings or seek their votes before taking certain actions.

• It’s easier to plan future expenses. Your monthly loan payment is a fixed cost figured into your company’s budget. This allows you to plan for other expenses.

The potential disadvantages of using debt financing include:

• You must pay back your loan. Even if your company collapses, you still owe the debt you took on and must pay it back with interest. However, if this happens, it may be helpful to speak to your lender about options to make your payments more manageable.

• You may have to use your personal finances to guarantee your loan. Even though the company is taking on the debt, some lenders may require that they review your personal finances and use your personal assets to secure and guarantee the loan.

• Your monthly expenses are higher. With debt financing, you have a required monthly payment. This raises your business expenses and makes less cash available for emergencies or other expenses.

• The lender may impose restrictions. It’s common for your lender to restrict your company’s activities that could impact them as your lender. For example, they may not allow you to seek additional financing options elsewhere.

• It raises debt-equity ratio. The larger a company’s debt-equity ratio, the riskier it is considered by lenders and investors. The ratio shows how much of your company’s financing is provided by debt vs. equity. The lower the ratio, the easier it is for your company to borrow money in the future.