Debt vs Equity Financing - Which is Best to Fund Your Business?

There are many reasons why you might need to secure funds for your business.

Perhaps you’re struggling in the post-COVID climate and need to introduce new cash flow or cash relief, or maybe you want to purchase assets, execute growth plans, or refinance existing funding into a different, more manageable form.

Whatever you need to raise funds for, there are two main types of financing you can look at: equity financing and debt financing. But which is best for your business – debt vs equity financing? Here we take a look at the pros and cons of each.

What is Debt Financing?

Debt financing is when you borrow money from external lenders, such as banks, building societies and credit unions. In this arrangement, you typically agree to pay the lender back set monthly repayments, over a fixed period (long or short term), at a predetermined rate. You’re also charged interest.

Types of debt financing include:

• Term loans and credit facilities – including business loans, overdraft services, lines of credit, equipment leasing, asset financing
• Store credit – often offered when buying furniture, technology or equipment
• Trade credit – involves speaking to your suppliers and requesting to delay the payment of goods or services
• Cash loans – provided by finance companies, often online, typically at a higher rate than banks
• Outstanding invoices – factor companies buy your outstanding invoices at a discounted rate
• Borrowing from family or friends – often done through a debt financing arrangement

Debt financing can be split into two types: secured and unsecured debt financing.

Secured debt financing is secured by an asset (either personal or business) and includes bank loans, overdrafts, outstanding invoices, and equipment leasing. If you can’t pay back your debt, lenders have the power to seize your assets.

Unsecured debts include credit cards, unsecured loans, online business loans and merchant cash advances. Unsecured lenders have no claim on your assets, but they can take action if you fail to make repayments, such as calling in a debt collector.

What is Equity Financing?

Equity financing typically involves receiving capital in exchange for rights in your business. Examples of equity funding include seeking private investors who contribute funds for a share in your profits and equity or floating your business on the stock market for public funding.

Additional sources of equity financing include:

• Venture capitalists – where big corporations invest large sums in start-ups
• Crowdfunding – involves asking people to donate money (usually online)
• Family and friends – offering a partnership or share in your business in return for equity
• Cash loans – provided by finance companies, often online, typically at a higher rate than banks
• Employee share/ownership plan – offering employees a share of your business in return for equity
• Government – grants may be available for R&D, expansion, innovation and exporting

Another type of equity financing is ‘bootstrapping’, which is where you raise funds from your own personal finances and business revenue. This is often a first step in seeking finance for your business, and lenders will expect some self-funding.

Debt vs Equity Financing – Pros and Cons

Both debt financing and equity financing have their pros and cons, as follows:

Debt financing pros

• You aren’t giving up any control of your business, meaning you make 100 per cent of the decisions and keep 100 per cent of the profits.
• Once you’ve paid the debt back, your liability is over. You only borrow what you need and it works out cheaper over time.
• You can get tax deductions for business debt, which can make a huge difference in your net profits as your business grows.

Debt financing cons

• You have to make repayments, no matter how well your business is doing. Also, be aware that variable rates may change, increasing payments.
• If you default on payments, you could be putting your personal assets and savings, such as your home, cars and kids university fund, at risk.
• Too much debt can negatively impact profitability and how much your business is worth. This can make raising equity more difficult in the future.

Equity financing pros

• It has the potential to bring in a lot more money for your business. This can help you grow more quickly. Plus, it can help you secure debt later.
• If you’re not making a profit, you don’t have a debt to pay. This means you won’t hinder growth or make quick decisions just to service it.
• With equity financing often come business partners with the knowledge, experience and connections to help you succeed.

Equity financing cons

• When you receive equity, you often lose complete control of your business. Partners may want to make decisions or could even end up taking over.
• Reduced ownership means that you have to split your profits. It could also mean you have to give stakeholders profits before you get your share.
• It can take a lot of time and effort to negotiate equity financing. You typically have to develop a powerful pitch to get people on board.

Weighing up Debt vs Equity Financing

There are pros and cons to both debt financing and equity financing, so which is best? Ultimately, it comes down to your current business situation, how accessible debt or equity is to you, and how important it is to you to retain control.

If you’re experiencing financial difficulty or are in a high-risk industry, you may find it difficult to secure debt financing from banks and other lenders. Equity financing, such as crowdfunding and private equity, may therefore be your only option. These also leave you free of repayment obligations.

If your business is performing well and growing, on the other hand, you would be more likely to secure debt financing at a lower effective rate. You can feel secure that you can pay them back. In this position, you can also look at angel investors, venture capital and an employee/ownership plan.

In reality, most companies have a mixture of both debt financing and equity financing.

When considering debt financing or equity financing for your business, get your business accounts are in order, assess your creditworthiness and consider whether you need funding. Also, make sure you understand what each means for your business, both in the short and long term.

It’s easy to make the wrong decision. So, if you’re experiencing financial difficulties and seeking cash to stay afloat, we recommend engaging a specialist financial broker who can point you in the direction of the right financer, ensuring you choose the right option and get the best rate.

If you need funding to help your business out of distress, get in touch with our experienced team today on 1800 861 247 or via the contact form. We can help you assess your situation and explore your options.