Last editedMay 20203 min read
When you’re attempting to drive growth and take your business to the next level, you may wish to consider outside investment. There are a broad range of options for entrepreneurs seeking access to capital, from crowdsourcing and government grants to accelerators and venture capital funds. But two of the most prominent sources of investment are debt and equity financing. Find out more about the advantages and disadvantages of debt and equity financing with our definitive article. First off, what is debt and equity financing?
What is debt financing?
In short, debt financing refers to borrowing money from a lender, usually a bank. There are several forms of debt finance, including loans, credit cards, overdrafts, and lines of credit. You’ll pay back the money you received over time, as well as any additional interest or fees. Access to debt finance has a (relatively) low barrier to entry, so many start-ups can take advantage of this form of financing.
What is equity financing?
Equity financing is a way of raising capital where you sell shares in your company. For example, you could receive $5,000 for 5% of the business (as well as 5% of any future profits). Equity financing comes in many different forms, including angel investment and private equity firms. Unlike debt finance, you don’t need to make repayments, as your investors will get their money back through profits.
Pros and cons of debt finance
The main advantage of debt finance is the fact that you retain control of the business and don’t lose any equity in the company. This means that you won’t need to worry about being sidelined or having decisions taken out of your hands. Another key benefit is the fact that it’s time-limited. Once you’ve paid back the debt, your liability is over. That’s one of the main differences between debt financing and equity financing, which continues in perpetuity.
Of course, there are also negatives to consider. With debt finance, you’ll need to make repayments, and if you’re unable to repay, the lender may end up taking the assets/guarantees you used as security. Furthermore, it’s easy for the cost of your debt to spiral out of control if you don’t have a full understanding of your fees, especially if you’re on a variable interest rate loan. It’s also worth noting that businesses in risky industries with inconsistent cash flows may have a more difficult time receiving debt finance.
Advantages and disadvantages of equity financing
In many cases, the advantages of equity finance revolve around the addition of equity partners to your team. From angel investors to private equity funds, equity finance can provide you with fantastic sources of expertise and advice. This can help you take your business to the next level much more quickly than would otherwise be possible. Furthermore, if you choose an equity financing option, you won’t need to worry about repaying debt while you’re building your company.
However, there are multiple disadvantages associated with equity finance. Most importantly, there’s the loss of control. By giving away partial ownership, you’re also giving away a certain amount of decision-making power, and in some cases, you may even end up being forced out of the company. Then, there’s the economic side. By giving up a certain proportion of profits for the rest of the business’s life, there’s a good chance that equity will end up being more expensive than debt finance.
You should also consider the fact that getting and managing equity finance can be a long, drawn-out process. As well as the initial time spent chasing the funding, you’ve also got to spend time managing your shareholders and keeping them up to date on the progress of your company. When considering the advantages and disadvantages of debt and equity financing, it’s worth remembering that debt finance is likely to be a much faster and smoother process.
Choosing between debt and equity financing
After considering the difference between debt financing and equity financing, what’s the best choice for your business? When assessing the pros and cons of debt and equity financing, it’s important to think about what you value in your business. Do you need to retain full control or would the added expertise of investment partners be a major boon to your company? You should also consider the monetary side. Debt finance is preferable if you can accept the repayments, as it may end up costing you less than equity finance in the long run.
By understanding the pros and cons of debt and equity financing, you can determine which form of outside investment is likely to be most beneficial for your business at its current stage of development.
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