Each type has different repayment obligations and expectations, and they can often be combined when a business is trying to raise capital.
Debt vs Equity Financing: Which Is Best for Small Businesses?
The main difference between debt vs equity financing is their return on investment (ROI). Debt financing has repayment obligations in which you, the borrower, pay back the loan with interest, whereas equity financing involves giving up ownership stakes in exchange for funding with no expectation of repayment.
Debt financing | Equity financing | |
|---|---|---|
ROI | Requires repayment of principal and interest on a schedule | Requires offering ownership stakes in exchange for funds |
Ownership | Enables you to retain ownership | Means you give up some ownership control |
Funds | Allows you to utilize funds as you see fit | Allows investors to give input on how funds are used, as well as on scaling the business |
Use case | Is optimal if you seek to maintain total ownership control of your business | Is best suited if you want to offer equity stakes rather than go into debt |
Debt financing
Debt financing involves borrowing funds from a lender, expecting those funds to be repaid with principal and interest. This is a very common form of financing, usually via a loan, that provides a borrower with a designated amount of capital for their business.
That said, lenders may impose certain restrictions or stipulations on how funds can be utilized. There is also a level of risk involved with borrowing funds, as in the event of default, there can be potential consequences for both parties. As such, borrowers will often have to supply collateral of some sort to help mitigate risk to the lender.
Check out our guide on how to get a small business loan to learn more about the application process and how to increase your approval odds.
Equity financing
Equity financing doesn’t involve borrowing funds but rather offering equity stakes in exchange for financing. With this, instead of repayment, a percentage of ownership control within your business is given to the investors who provided funds.
This method of financing requires no debt obligation or financial expense of your business but rather allows investors to give input on how to scale your business to ensure their ROI. This allows you to raise capital and grow your business without entering into debt.
When to choose debt vs equity financing
When deciding which option is best for your business, there are various factors to consider, mainly concerning how your business is structured, market conditions, and how much financing you need. In some cases, you can utilize both debt and equity financing to source funds for your business; it really depends on your preference and factors such as budget, ownership, and business structure.
That said, if you need help deciding, consider the following:
Debt financing | Equity financing |
|---|---|
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Factors to consider when making a financing decision
When determining where to source capital for your business, you should keep a few things in mind to ensure you pick the best option for your business needs. Take the following points into account before coming to a decision:
Alternatives to debt and equity financing
Seeking an alternative outside of debt or equity financing may be a bit tricky, as they make up a vast majority of business financing sources. However, in the case you are exploring all of your potential financing alternatives, consider the following:
- Rollover for Startup Businesses (ROBS): If you don’t want to manage debt obligations or give up portions of ownership control within your business, you may be able to seek business financing through your 401(k). This transaction is known as a ROBS, which allows you to access retirement funds tax- and penalty-free. Check out our ROBS ultimate guide to get started.
- Small business grants: These may be a suitable option to obtain funding without entering into any type of financial agreement. While they can be competitive, it’s a risk-free way to apply for funding through various channels. To find a potential grant opportunity, see our roundup of the best small business grants.
- Crowdfunding: There are various forms of crowdfunding, which include debt-, equity-, donation-, and rewards-based models. These public campaigns are commonly hosted on an online crowdfunding platform, which allows your funding goals to be reached by a large audience of interested investors. Our list of the best crowdfunding sites for small businesses will help you find a platform.
If you’re a startup business, refer to our guide on alternative funding for startups for an in-depth look into how to secure financing for your business.
Frequently asked questions (FAQs)
Debt financing most commonly takes the form of a loan. For example, if a business is looking to acquire a commercial real estate space to grow its operations, it may need to seek out a loan to purchase the property. In this case, it would enter into a debt financing agreement with a lender and repay the loan over time. This requires a debt obligation on its part and would be considered an expense.
The main advantage of debt financing over equity financing is maintaining ownership control of a business. With debt financing, you can access capital without having to provide equity stakes that would ultimately impact your level of control. With equity financing, there is the expectation that ownership percentages will be offered in exchange for funding with no repayment obligations.
Both have various risks worth considering. With debt financing, most risk is associated with default, in that you’ll be legally on the hook if you violate the terms of the financing agreement. This can involve pursuing personal funds or asset seizure. With equity financing, most risk lies in giving up portions of ownership within a business, ultimately giving the business owner less control over operations and important business decisions.
Bottom line
Overall, both debt and equity financing can be great ways to source funding for your business needs. Depending on your preferences, business model, and qualifications, one option may be more suitable. That said, be sure to do your research before entering into any form of financing agreement.
