All forms of external finance are generally categorized into one of two types: debt or equity finance. They are two distinct business financing options and each one has its respective pros and cons. Several enterprises prefer to utilize a combination of both methods. In this article, we explore the terms “debt and equity” and examine some of the core differences so as to assist you in making the best financial decision when raising funds for your business.
What is Equity Finance?
Equity finance involves raising finance by selling stakes or shares in your company. There are different types of equity finance, some of which include private equity firms, angel investors, venture capitalists, and equity crowdfunding platforms. Some businesses can choose to raise several rounds of equity financing from various types of investors throughout the lifecycle of the business.
Equity investors then profit from their investment by receiving dividends (a portion of the organization’s profits – this is more typical for mature businesses) or by selling their shares eventually. Equity investors usually have a keen interest in the growth of the company and having the right investors will provide the useful contacts and expertise the company needs to grow.
What is Debt Finance?
Whether you have once taken out a car, student, or mortgage loan, there’s a likelihood that you are already familiar with debt funding. Basically, it entails borrowing a huge sum, which the business then repays over time, in addition to an interest rate that has been agreed upon.
There are various forms of debt finance, including business loans, asset finance, commercial mortgages, and working capital facilities, such as invoice discounting and overdrafts. A loan can be secured against a personal asset of yours, or unsecured. As a result of the reduced level of risk to lenders, secured debt is typically cheaper and easier to obtain.
Here’s the Difference Between Equity Financing vs. Debt Financing
There are certain key differences you must know before you decide on which of these two funding options to choose.
Debt finance requires that you repay the loan in addition to an agreed-upon interest over a specified period of time, usually in monthly installments. On the other hand, Equity finance imposes absolutely zero repayment obligations, with means you have more funds than you can channel into expanding your business.
Of course, investors look forward to making great returns on their investment, however, this can only be achieved if and when your company does well in the industry. Hence, unlike debt financing which presents a pre-determined cost, equity financing has a more variable cost, because it’s a stake in the future value and earnings of your business.
When equity investors purchase a share in your company, your own shareholding would reduce, but with debt financing, you retain 100% ownership. Nonetheless, it might be worth considering a decreased ownership in the business if your equity investor is willing to invest a lot of resources (which could be both monetary and non-monetary resources, like access to contacts and expert guidance) that empower you to build a bigger, more successful enterprise.
In debt financing, a lender may request a collateral asset from the borrower as security for the loan, such as equipment or property. If the borrower is unable to pay back the loan, we all know what happens: the lender would claim the asset as payment for their money. However, with equity finance, you are not required to put up any form of collateral whatsoever.
Access to finance
Start-up businesses with no physical assets or trading history and are unwilling to use personal security, might have a tough time securing debt finance, especially from traditional lenders. On the other hand, equity investors tend to invest in businesses that are considered extremely high risk by many debt financing providers.
Most equity investors might demand a board seat. This means that they will have a contribution to the general direction of the company and be actively involved in the decisions of the company. This can be a blessing to the company if you have the right investor(s) who will add valuable expertise and experience to the boardroom and will also be willing to pave the way for you with their network of contacts. A lender, by contrast, has zero ownership and thus isn’t involved in company decisions.
Equity finance might not be the best option for you if you are in a hurry to raise capital for your company. Finding the right investor can take a considerable amount of time, after which you have to discuss the conditions of the deal and organize the necessary diligence process, among other intricacies. A lot of legal work is also involved. Debt finance however tends to be more straightforward, as you can even secure the funds in as little as a couple of weeks or perhaps some days from some lenders.
Which is Best for You: Debt Financing or Equity Financing?
At the end of the day, the financing option you settle for will be determined by your individual needs, including the nature of your enterprise as well as its stage of development.
You may want to consider debt finance if:
- Your cash flow is consistent, and you have a tested business model
- You want to retain sole ownership of your business
- You would prefer a short-term relationship that is terminated as soon as the loan is repaid
- You find it easier to manage cash flow and forecast expenses provided you know, in advance, how much capital and interest you are required to pay
And you should consider equity finance if:
- Your business has a limited financial history or no collateral
- You don’t like the idea of regular loan repayments
- You have certain plans for growth, such as expanding operations or migrating into new markets, which will cost a huge amount of capital (equity financing typically allows you to raise higher amounts)
- You want to gain from the experience and skills that an investor has to offer
We hope this article on equity financing(1) vs. debt financing(2) has been very useful to you. Keep in mind that you’re not necessarily mandated to pick one or the other; you can choose to employ a combination of debt and equity financing if you feel that would best suit your business needs. Importantly, be sure to do your homework and research carefully before you finally choose any financing option.