What Is Debt Financing?

Some things in business are simple: finance, good; debt, bad. So, what is debt financing?

Debt financing meaning

Debt financing refers to a financial transaction wherein a company borrows money that needs to be paid back at a later date. There are many different debt financing options, including bank loans and loans from friends/family, although online lenders and peer-to-peer lending (P2P) are also possibilities. Companies of all sizes have the option of using debt financing vs. equity financing if they want to secure funding, but start-ups are most likely to need to utilise these tools.

Debt financing vs. equity financing

Debt financing means, as the name suggests, going into debt in the form of a loan that is due to be repaid. Equity financing is the opposite – it’s when a company sells a part of the business. There is no interest involved in equity financing, and it doesn’t have to be paid back. However, it is also higher risk for investors, as there is no promise of anyone getting their money back.

While you can head to a bank for debt financing, equity financing can be trickier, especially if friends or business partners aren’t willing to put in their own money. Business angels and investors are potential options, but they will not do so with the same blind faith as friends or family and you will need to prove your business is likely to grow.

Both debt financing and equity financing have their own pros and cons, and ultimately, it’s down to the individual business owner as to which represents the best option for their company.

Advantages and disadvantages of debt and equity financing

Debt financing and equity financing continue to be useful tools for businesses around the UK. However, there is no reason a business cannot use both. For example, an entrepreneur may start their business with the help of a personal capital investment from a friend in exchange for part of the company, and then add to this with a business loan, thus using both debt financing and equity financing. Here’s a little more information about the advantages and disadvantages of debt and equity financing.

Debt financing pros

• The business owners don’t have to give up control

• It is very straightforward – you borrow, then you repay

• There’s no need to share profits with the lenders

• You can, generally, spend these funds how you want

• Interest can be deducted from your business tax

• Once the debt is repaid, there is no further involvement from the lender

Debt financing cons

• The debt must be repaid, no matter what

• Interest rates can change unless you have a fixed rate loan

• Too much debt weighs heavily on a business’s financial health

• You may need to put up collateral, such as your home

• A significant amount of debt can scare off future investors for equity financing

Equity financing pros

• Equity financing doesn’t have to be repaid, even if the business fails

• Investors can share skills and knowledge and introduce you to their network

• There’s no interest rate

• Increased capital, not debt

Equity financing cons

• You no longer own 100% of your own business

• Loss of control – once someone has equity in your company, they have a say on key decisions

• Profits will need to be shared with all your investors

• The process of courting serious investors can be time-consuming

So, there you have it – debt financing can be an excellent way for growing businesses to obtain the capital they need to develop their business proposition. But remember, you can always use it alongside equity investment (or other sources of funding, i.e., crowdfunding, business grants) to maximise your chances of success. 

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