Debt financing vs equity financing – Which one is the best for you?
30 Oct 2019
Small businesses need capital for rapid growth and expansion. Now, there are 2 ways of arranging capital for business. The first one is debt financing and the second one is equity financing. Both have pros and cons. You need to evaluate them properly and then make the final decision.
What is debt financing?
In plain and simple terms, debt financing implies that you borrow money from a lender to expand your business. This is essentially a business loan or a commercial loan from a bank or a personal loan from friends or family members.
Lenders give you money for business development, and you have to pay back the principal amount together with the interest within a specific period.
Since you have taken out a loan, so it means that you have incurred debt. This is why it’s called debt financing.
The most common types of debt financing are:
- SBA loans
- Equipment leasing
- Commercial loans
- Working capital loans
The biggest disadvantage of business loan is that you have to pay off the debt, no matter who the lender is. As long as your business is doing well, you can make the required monthly payments comfortably. But what if your company incurs a loss? How will you make the payments?
You have 3 options. The first option is to go for equity financing, which we will discuss in the next section. The second option is to take out a business debt consolidation loan and pay off your existing debts. The third option is filing bankruptcy.
All the 3 options have pros and cons. But you hardly have any option. Lenders are money-oriented. They want their money. If you don’t pay off the business debt, then lenders can assign the accounts to debt collection agencies. Now, debt collection agencies are quite ruthless. They can go to any extent for collecting repayments. In fact, some of them twist the fdcpa laws to collect as much money as possible. In this case, also, people have 2 options to resolve this problem.
Option 1: The first option is to contact fdcpa lawyers and find out the ways to deal with debt collectors smartly. Since the fdcpa lawyers have profound knowledge on the debt collection laws, so they can help you to use the laws to safeguard your rights.
Option 2: Your second option is to pay off your debts as soon as possible. Now, the problem is, once your debts are assigned to collection agencies, you have to be prepared for a tough negotiation process. The goal of the collection agencies is to make you pay the maximum amount. Unless you negotiate with them smartly, you’re in trouble. In this situation also, fdcpa lawyers can help you.
What is equity financing?
Equity financing is when you sell the stocks of the company to angel investors and venture capitalists in exchange for money. There is no lender involved in equity financing. Unlike debt financing, you don’t have to make monthly payments or pay an interest rate. Rather, what you have to do is, share profits with investors.
In equity financing, you lose a portion of your ownership in the company to the investors. You need to give a percentage of the company to the investors since they are providing the much-needed capital.
In equity financing, you have more cash flow than debt financing since there are no monthly payments involved. You can invest the money for business development.
The most common types of equity financing are:
- Venture capitalists
- Angel investors
- Private investors
- Employee stock ownership plan
A brief comparison between debt financing and equity financing
|Debt financing||Equity financing|
|You have to pay off the loan.||You don’t have to pay back money if the company fails.|
|You have limited cash flow.||You have a generous cash flow.|
|You don’t have to share the profits with the lender.||You have to share profits with the investor.|
|You may have to give up your assets.||You won’t have to give up your assets.|
|You can enjoy tax benefits on the interest you pay.||There are as such no tax benefits. You can only gain credibility via investor networks.|
|You should have a personal guarantor or collateral.||You don’t need a personal guarantor.|
|Lenders won’t say anything regarding how your business should be run.||You have to consult your partners and investors before making important decisions that may affect the future of the company.|
|You have to take all of the risks.||The investors will take all of the risks.|
Debt financing vs equity financing – Which one should you opt for?
Both have pros and cons. It’s tough for small entrepreneurs to secure equity financing. On the other hand, venture capitalists are more interested in big shot companies.
Usually, angel investors are ready to invest $300,000 and want a 50% stake in a company. Are you ready to give a 50% partnership to angel investors?
If you’re a small entrepreneur, then debt financing is perhaps the best option for you. Established companies have better access to financing options than you. They are more likely to qualify for equity financing.
The only risk in secured business loans is that you may end up losing your assets in the event of loan default. But you have to take some risks. Right?