When evaluating debt vs equity financing, there are some key aspects to consider to determine which is best for your business. These factors include qualification requirements, costs, repayment terms, and effects on control of your business. Additionally, you will need to consider how quickly you need funding and the ease of access to those funds.
What Debt Financing Is
Debt financing provides funding for your business by borrowing from a lender. This funding comes in various forms, but always involves an agreed-upon method of repayment. Funds are repaid in a series of payments and generally include a percentage of interest due to the lender in addition to the funds borrowed.
What Equity Financing Is
Equity financing is a method of financing for startup and emerging businesses, wherein funds are received in exchange for an equity stake in your business. Equity may be paid out through the sale of company shares, through a promise of future payout by way of a convertible note, or through a simple agreement for future equity.
When Debt Financing Is Right for Your Business
Businesses that need a quick source of funding for working capital or other business needs will likely find debt financing to be an appealing option. Debt financing is also well suited for businesses that only need small amounts of funding and for business owners who want to maintain complete ownership control of their companies.
When Equity Financing Is Right for Your Business
Businesses that may benefit from equity financing include those that have the potential for high-growth and the ability to scale quickly, and those that need large amounts of funding to obtain their goals for growth. Additionally, due to the amount of time it takes to receive funds, equity financing is a good option for businesses that don’t have immediate financial needs.
Debt vs Equity Financing at a Glance
Based on personal/business credit and history
Based on projected future growth
Interest and fees
Equity payout and/or dividends
Payment of equity to investors at predetermined times
Effect on Ownership
Partial ownership transferred to investors
Ease of Access
Easy to obtain
Difficult to obtain
Types of Debt Financing
There are many different types of debt financing available to small businesses, and each meets specific business needs. However, the three most common types of debt financing available to small businesses are business loans, lines of credit, and credit cards. The type of debt financing that will be best will depend on the specific funding needs of your business.
Small business loans come in many different forms, with different rates and terms depending on the loan type. SBA loans offer longer repayment terms and lower interest rates (starting as low as 7.75% for working capital) than many other business loan options, but are more difficult to qualify for than online business loans.
Business Lines of Credit
A business line of credit is a form of business loan that allows you to borrow and repay funds over and over again. You only pay interest on the amount of funds you have borrowed, rather than on the full amount you have been approved for. Some of the best small business lines of credit can provide funding in as little as two days.
Business Credit Cards
Businesses with recurring working capital needs may find a small business credit card to be a relatively cost-effective alternative to equity financing. Many credit cards offer introductory periods at 0% APR, as well as cash back or rewards programs. These added incentives can be beneficial if your business regularly uses credit cards for working capital. A business credit card can be a simple source of funds for your immediate small business expenses.
Types of Equity Financing
The primary sources of equity financing include financing from angel investors, venture capital, and crowdfunding. Each source of equity funding is slightly different and geared towards businesses with slightly different financial needs. However, each of these options offer the advantage of not requiring recurring payments to repay the funds.
Some of the most common types of equity financing come from:
Angel investors are individual investors who provide funding in exchange for an equity stake (partial ownership) in your startup business. While your business is still in the startup stage, you may want to consider seeking out an angel investment firm. Because angel investors are fronting their own personal money into your business, they will want to vet both your business idea as well as you personally.
Venture capital is an equity financing option that can provide large sums of money to startups with high growth potential. In exchange for these funds, venture capital investors will require an equity stake in your business. Venture capital is a good financing source for businesses requiring funding from $100,000 to many millions of dollars in order to scale. To apply for venture capital funding, you must find the right venture capital firm, pitch your company, and pass its due diligence process.
Many small businesses in the startup phase prefer crowdfunding as a source of equity financing. Crowdfunding utilizes small amounts of money contributed by many individuals to collaboratively fund your business. This collaboration is often facilitated through a crowdfunding site. In most cases, crowdfunding contributors are given something in return for their investment, whether it be equity, promise to repay, or a reward.
Debt vs Equity Financing: Qualification Requirements
Qualifying for debt financing is very different than qualifying for equity financing. While debt financing lenders typically have very specific qualification metrics they use to evaluate potential borrowers, equity financing is based largely on future growth projections. This key difference makes it very difficult to know if equity investors will be interested in your business.
Debt Financing Qualification Requirements
The exact qualification requirements for debt financing vary not only on the type of financing, but also by lender. In general, there are three qualification requirements to be aware of. Qualifying is most often based on your personal and business credit score, how long your business has been operational, and the amount of revenue it is producing annually.
The typical qualification requirements for debt financing include:
- Credit score: Most lenders will have a minimum credit score requirement that you must meet to be considered eligible for funding. In general, there are financing options available for those with credit scores of 600 or greater.
- Time in business: In general, it is easier for more established businesses to obtain debt financing because many lenders set a minimum time in business requirement you must meet in order to qualify.
- Annual revenue: To ensure you will be able to repay your loan, lenders often require that your business revenues exceed a certain level before they will be willing to provide you with debt financing.
Equity Financing Qualification Requirements
Equity financing investors seek businesses that are in high-growth industries or that have high-growth potential. Because investors are often investing their personal funds, they seek investment opportunities that have the potential to provide large returns in a relatively short period of time.
The standard qualification requirements for equity financing include:
- High-growth potential: Equity financing investors seek to fund businesses that have high-growth potential in order to maximize the gains on their investment.
- Ability to scale quickly: Investors want to be able to realize their gains quickly so they can invest funds in other opportunities. For this reason, they seek businesses that will be able to grow quickly.
Unlike debt financing that often has specific qualification metrics that a business must meet in order to receive financing, the requirements for equity financing are more speculative. Investors base their decisions on prospective growth rather than proven history of the company.
Debt Financing vs Equity Financing: Costs
The costs of debt financing versus equity financing are very different and therefore difficult to compare. With debt financing, there are measurable costs that allow you to calculate an estimated cost of capital prior to receiving funding. The costs of equity financing are not as clear, and involve a future equity payout as well as the sacrifice of partial ownership interest.
Debt Financing Costs
When arranging debt financing, there are a number of different costs charged by the lender. These costs include the interest rate charged on the borrowed funds and any additional fees. Together, the interest rate and fees are combined to calculate the effective APR on the borrowed funds. Additionally, some lenders charge a penalty for early repayment of the debt.
The typical costs associated with debt financing include:
- Interest rate: The primary cost associated with debt financing is the interest rate charged on the borrowed funds. The interest rate is a percentage fee based on the amount borrowed, and can be assessed daily, weekly, monthly, or annually.
- Origination fees: Some lenders will charge you fees associated with the underwriting and creation of the loan. These administrative fees, charged by the lender, are often referred to as origination fees and are based on the amount of money borrowed.
- Annual percentage rate (APR): The APR of a loan is the effective interest rate of the loan, and takes into account both the interest rate charged as well as any fees associated with obtaining the loan.
- Prepayment penalties: Some loans have prepayment penalties associated with them. As such, you will be charged a fee in the event that you repay the loan prior to its scheduled maturity date.
Equity Financing Costs
The costs of equity funding vary based on the type of equity financing and your agreement with the investors. In general, the costs of equity financing are made up of future equity payouts to the investors. However, there is the additional cost associated with this type of financing related to the loss of total business control as ownership becomes diluted.
The costs you will experience when utilizing equity funding are:
- Business equity: When you first receive equity financing, the cost is seen as a percentage of ownership that you are giving up. Eventually, the ownership percentage will be cashed out as a percentage of the company’s worth. While the investor holds stock in the company, you may be required to pay out dividend payments on earnings.
- Business control: A non-monetary cost related to receiving equity financing is the reduction of your ownership in the company. However, the sharing of ownership interest also exposes your business to the business acumen of the investors, which may prove to be just as valuable as the funding they invested.
Debt vs Equity Financing: Repayment Terms
When comparing debt financing versus equity financing, one of the major differences is the means by which the funding is repaid. With debt financing, the borrowed funds are repaid by a predetermined repayment schedule that impacts your monthly cash flows. Equity financing is not repaid; however, there is an equity payout associated with the funding.
Debt Financing Repayment Terms
Debt financing involves recurring payments to repay the amount of funds borrowed. These payments may be daily, weekly, or monthly, depending on how your repayment agreement is organized. Additionally, you will have an expected end date of your payments, known as the maturity date. Upon reaching the maturity date, the borrowed funds will be paid in full (assuming that no payments were missed, and all payments were made in accordance with the repayment agreement).
The general repayment terms you can expect with debt financing include:
- Recurring payments: Debt financing requires regularly recurring payments until the debt is repaid. These payments may be daily, weekly, or monthly.
- Defined maturity date: Due to the nature of debt refinancing, you will have a defined amount of time in which to repay the debt. As such, payments can easily be budgeted, and you will know when to expect payments to cease.
Due to the recurring payments involved with debt financing, utilizing this form of funding will have an impact on the monthly cash flow for your business. Your monthly cash flow will be reduced by the amount of your monthly payments. This is in contrast to equity financing, which has no monthly payments, and thus your business cash flow is not impacted.
Equity Financing Repayment Terms
Unlike debt financing that has very specific and defined repayment terms, the repayment terms for equity financing are not as structured. Equity financing does not require regularly recurring payments. Typically, the equity agreement will allow investors to withdraw their share of equity at a specific time, or at such time that a specific event occurs for the business (e.g., acquisition).
The repayment terms you can anticipate with equity financing are:
- No regularly recurring payments: With equity financing, there are no regular payments required from the business. The funds invested are not repaid to the investors.
- Equity payout tied to an event: In lieu of repayment, the investors will receive an equity payout in proportion to their ownership interest at the time of a defined business event (e.g., initial public offering).
Debt Financing vs Equity Financing: Effect on Ownership
One of the major differences when considering debt versus equity financing is the effect on ownership interest of your company. Debt financing will have no impact on ownership interest—the lender will not require any ownership control in your business. Conversely, equity financing will require you to give up partial ownership interest to the investors.
Debt Financing Effect on Ownership
With debt financing, you retain complete ownership of your business. The lender will not require any ownership interest in your company, nor will it be involved in any of your business decisions going forward. Some forms of debt financing may require continued financial reporting to the lender; however, such reporting would only be required to monitor your compliance with specific loan terms.
Documents you may be required to provide to the lender on an ongoing basis include:
- Profit and loss statement
- Bank account statements
- Updated personal and business balance sheets
Equity Financing Effect on Ownership
Receiving equity financing often requires that you hand over a certain amount of ownership interest to your investors. This ownership interest is how the investors make money off your business. As partial owners, they are entitled to part of your profits and may contribute to the decisions of the business. Equity financing involves a significant amount of investor oversight over the operations of your business.
Debt Financing vs Equity Financing: Ease of Access
When it comes to ease of accessing debt financing versus equity financing, debt financing is far easier to obtain. With the variety of lenders and financing products available, there are financing options available for nearly every type of business situation. Finding investors to provide equity financing can be a much longer and more arduous process.
Debt Financing Ease of Access
The diversity of debt financing, coupled with the variety of available lending sources, makes it relatively easy to obtain. Regardless of the stage of your business or your credit history, there is likely a lender that will provide funding. Some of the fastest business loans available can provide funding in as little as 24 hours. Additionally, there are even lenders that provide bad credit business loans.
Equity Financing Ease of Access
Equity financing can be difficult to obtain because it requires convincing investors to commit their personal funds to your business. They must also feel confident in your business’ ability to succeed. It can take weeks or months to locate an investor that may be interested, and additional time beyond that to convince them that your business is a worthwhile risk.
Pros & Cons of Debt Financing
Advantages of debt financing include the ease of accessing financing, the ability to retain ownership control, and the predictability of scheduled payments. Conversely, the disadvantages of debt financing include the fact that regular payments impact cash flow, there are qualification requirements that must be met, and that debt financing may impact your credit score.
Pros of Debt Financing
Some of the advantages of debt financing include:
- Scheduled repayment: With debt financing, you know when your payments are due and how much you need to repay. This makes budgeting for future business needs easier.
- Retain ownership control: Debt financing does not require that you give up any amount of ownership control.
- Easily accessible: There are many different lenders that offer business debt financing through a number of different product types. Finding a lender and product that meet the needs of your business is far easier than obtaining equity financing.
Cons of Debt Financing
Some of the disadvantages of debt financing include:
- Impact of cash flow: Because debt financing requires regular payments to repay the amount borrowed, there is a direct impact on the business’ monthly cash flow.
- Qualification requirements: Qualification requirements can make it challenging to procure debt financing as a startup. Business owners may therefore resort to using personal loans for business seed money.
- May affect your credit: In the event that you miss payments on your loan, your credit may be impacted. However, repaying in full and on time can have a positive effect on your credit.
Pros & Cons of Equity Financing
Some benefits of equity financing include the lack of monthly debt payments and the ability to receive large amounts of funding. Additionally, investors can offer valuable business guidance that isn’t available to many new businesses. Drawbacks to this type of financing include that obtaining equity financing can be a lengthy process, and it may require relinquishing some control over your business.
Pros of Equity Financing
Some advantages of equity financing include:
- No recurring debt payments: Unlike debt financing, which includes regularly scheduled payments to repay the borrowed funds, equity financing does not require regularly recurring payments.
- Large amounts of funding: With equity financing, you can receive much larger amounts of funding from investors than you would be eligible to receive through a typical small business loan.
- Investors bring valuable experience: Most forms of equity financing require that the investors be involved in major business decisions; your business can benefit from the business acumen of your investors.
Cons of Equity Financing
Some disadvantages of equity financing include:
- Relinquishing some control of your company: In exchange for equity financing, investors often require a percentage of ownership stake and a seat on your board. This ownership interest allows investors to be part of your business’ decision-making process.
- Obtaining equity financing can be difficult: Finding potential investors can be difficult, and the time it takes to present your business, allow for investment consideration, and to finally obtain funding can be a lengthy wait.
- Sharing business profits: In exchange for their investment, investors will become partial owners of your company. This partial ownership means that they will be entitled to a share of your business profits as well. Additionally, there may be tax implications depending on the structure of the investment.
When Bootstrapping Is Better Than Debt or Equity Financing
Small business owners who have personal or retirement savings may want to consider using personal funds to bootstrap their business expenses. Using your existing 401(k) savings through a rollover for business startups (ROBS) allows you to use money you already have to invest in your business.
By putting personal money into a business, there is no outside debt to repay and you aren’t sacrificing ownership interest in the company. While this may not be an option available to all small business owners, those who have personal funds available should consider bootstrapping their business expenses before taking on additional debts.
Debt Financing vs Equity Financing Frequently Asked Questions (FAQs)
A lot of information has been covered in this article about debt financing versus equity financing, including what each is, qualification requirements, costs, repayment, and the effect on business ownership. If you have any questions about any of the information presented here, you can post them in the Fit Small Business forum.
Some of the most frequently asked questions pertaining to debt financing versus equity financing are:
Is debt or equity financing riskier?
As a business owner, determining whether debt or equity financing is riskier isn’t simple. If you are uncertain that you will be able to make your debt payments, then debt financing can pose a significant risk. However, if you fear sharing business decisions with your investors, then you may find equity financing to be riskier.
Which is better—debt or equity financing?
Determining whether debt or equity financing is better for your business depends on the position of your business and your financial needs. Businesses needing large amounts of funding to quickly scale may be better suited for equity financing, while businesses needing funding for immediate working capital may find debt financing to be a better fit.
Is equity financing better than debt?
Equity financing is better than debt for some businesses. Businesses that need a significant amount of funding may not have the cash flow to support the debt payments that would be associated with that level of financing. In this situation, equity financing would be better than debt, which requires recurring payments.
When comparing debt versus equity financing, both can be valuable to businesses under the right circumstances. Businesses geared for high growth and rapid scaling will likely be able to entice equity financing investors, but those who are not comfortable relinquishing any ownership control may still prefer debt financing. Either financing option is a good business choice provided it meets the needs of your business.