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.
We can help
GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.