Debt Over Equity Financing: Which Direction Should Your Business Go?
Early in your company’s life, you have to decide how and who will provide capital funding. Not to mention, figuring out how much funding you’ll need.
Deciding how you’ll fund your business is one of the first decisions you’ll make as a business owner. Without funding, it would be hard, if not impossible, to get started. Therefore, considering your available investment options is key in the beginning.
But what are your options? Who can provide funding to your business? What is your obligation as the business owner? Ultimately, there are 3 main ways to raise capital: debt financing, equity financing or a hybrid of the 2.
Debt financing is one way of raising capital that involves borrowing money from investors. Investors do not hold an ownership stake and companies are expected to repay the loan on a specified date at a specified interest rate.
Equity financing involves selling shares of your company in exchange for cash. Investors do have an ownership interest and companies are expected to repay the vested amount with profits earned in the business.
Debt Financing Vs. Equity Financing: Which One Is Better?
In deciding which mode of financing is better, you should first understand the details and attributes of each.
With debt financing, investors are given the opportunity to earn interest on the money they loan you. Possible investors could be an individual or another business, inside or outside the company. Debt financing offers some tax benefits that equity does not. The interest paid or accrued on the debt is 100% tax deductible. Thus, reducing your taxable income and tax liability.
Because their return does not depend on profits, investors do not participate in the day-to-day activities of your business. Helping your business grow is not apart of their responsibility to you. Instead, their hopes are that you can stay in business long enough for them to be repaid. In the unfortunate circumstance, you do go out of business, lenders are given preferential treatment over equity investors.
Debt financing takes less time to acquire than equity financing. Usually, lenders, such as banks vet, approve and distribute funds within 30 days. Lenders also do not participate in board meetings or have a say in business decisions. As the founder, you are able to use the capital borrowed at your own discretion. This gives you greater freedom and more time to focus on growth and strategy.
Debt financing does have its drawbacks. One, most lenders would want to qualify you by running a credit check, reviewing prior year tax returns, reviewing your company’s financials or business plan. If you find that you don’t have the strongest credit score or all of your documents aren’t together, this will hinder your chances of being approved for a loan.
Another consideration is if your company is unable to pay back the debt financing, the bank or lender can seize your assets. Even if you have an LLC business, the bank may still require you to guarantee the loan with your personal financial assets.
Equity financing involves selling shares of your company for the purposes of raising capital. With this type of financing, you are giving up a portion of ownership.
With equity financing, you do not have to pay interest on the capital you raise. Your money can be fully directed at growing your business.
Because investor return is dependent on the performance of the business, investors tend to be more involved in the major decisions of the business. This could be an advantage or a disadvantage depending on what you are looking for. With the right investors, you can gain valuable insight and knowledge on your industry and avoid mistakes you would otherwise make on your own. At the same time, implementing decisions can be held up since investor input is typically required. There is a level of control you lose when accepting equity financing.
Money invested into your business as equity financing is not required to be repaid. So if your business fails, there are no financial consequences to the business or you.
The downfall associated with equity financing is the fact that you are selling shares or ownership in your business. So your investors have the right or claim to future profits of your business, indefinitely. It is not like debt financing, where you pay back a set amount of principal and interest and that’s it.
Equity financing is more time consuming than debt financing. It takes time finding the right investors, meetings and agreeing on an arrangement. It could take up to 6-12 months to complete the full process and receive equity financing.
Which One is Right for Your Business?
Deciding which one is better really depends on your business and/or industry. Usually, if your business requires a small amount of funding, $10,000 or less, debt financing would be the better choice. The reason being is equity financing usually involves significantly higher amounts.
Another consideration is if you want to give up ownership in your company. Some founders may not want to give up control of their business and others may value capital over ownership. It all really depends on your preferences.
Are you looking for guidance and/or expertise in growing your business? Equity financing may be the way to go. Equity investors want your business to grow because that means greater returns for them. With that, they will provide you with their insight to accomplish this. Debt financing only provides your business with capital and no additional support.
As a founder, you are presented with a lot of business decisions early on. From process, to marketing, to selecting vendors and much more. Capital funding is probably one of the most important decisions if not, the most important decision because it is the one that dictates how and when your business will get off the ground. Both equity and debt financing can help you achieve that but depending on your business, goals, and preferences, one is sure to be the best choice for you.