Should You Use Equity Financing or Debt Financing to Fund a Business?

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It’s impossible to start a business without money. These days, it’s possible to start some types of businesses with just a few thousand dollars. Still, most businesses need thousands, if not tens of thousands of dollars of initial investment before they can get up and running.

While some entrepreneurs can volunteer a portion of their own savings for the endeavor, most turn to the help of financing to get external monetary aid. And in the realm of financing, there are essentially two broad options: equity financing and debt financing.

Which one is better, and which should you choose when starting your business?

The Differences Between Equity Financing and Debt Financing

Let’s start by clarifying the differences between equity financing and debt financing.

In equity financing, you’ll receive an influx of capital from an investor in exchange for an equity stake of your company. For example, an angel investor might give you $50,000 upfront in exchange for a 5 percent ownership stake of your business. Depending on the arrangement, they may be entitled to 5 percent of the profits (and/or sale proceeds) moving forward.

In debt financing, you’ll incur debt, often by taking out a loan with a major financial institution, to get your money. Ideally, you’ll take the loan out as a business rather than as an individual. Either way, you’ll be responsible for paying the loan back incrementally and with interest. 

Depending on the type of loan you receive, there may be specific terms and conditions you must fulfill along the way.

Advantages of Debt Financing

There are several advantages of debt financing:

·         Easier accessibility. Generally speaking, it’s easier to get a loan than it is to secure equity financing. Most equity investors are picky about the projects they invest in, and they won’t be willing to volunteer their capital unless you can prove your business is capable of long-term success. Getting a loan, by contrast, is easy as long as you have decent credit.

·         Retention of company ownership. One of the most important advantages of debt financing is that you can retain complete ownership of the company. You won’t have to sacrifice your equity stake, which means you won’t have to sacrifice your future earning potential or profitability for short-term gain.

·         Retention of full control. Similarly, you’ll get to retain full operational control of the company. In equity financing, surrendering an ownership stake of the company often means allowing others to voice their opinions, and in some cases, dictate the direction of the company. With debt financing, you’ll get to continue making all the decisions.

·         Faster closing. It can take some time for underwriters to process a loan, but the process is still much faster than with equity financing. In some cases, debt financing can secure you the funds you need in a matter of days or weeks. Equity financing deals can take countless meetings and months of time to completely close.

·         Tax advantages. There are also some tax advantages to taking out a loan for your business. For example, you’ll be able to deduct the interest you pay on certain types of loans, reducing your tax burden and saving you money.

Advantages of Equity Financing

However, there are also some advantages of equity financing:

·         No extra fees or penalties. Some loans come with extra fees or penalties if you violate the terms of the agreement or miss a payment. Over time, these fees can accumulate and lessen the value of the loan.

·         No possibility of default. With a loan, there’s always a danger of default if you fall behind on payments. In equity financing, you won’t have to worry about it.

·         Minimal impact on credit. Equity financing isn’t going to affect your business’s credit score (or your personal score). By contrast, if you consistently miss payments on a loan, or if you end up defaulting, your credit score could take a massive hit.

·         Access to expertise. Giving up a portion of your ownership and control in the business isn’t always a bad thing. If you’re working with a seasoned entrepreneurial veteran, you’ll gain access to their industry knowledge and expertise.

·         No upper limit. Most financial institutions put a cap on what they’re willing to lend you. But in equity financing, there’s practically no ceiling (if you know who to talk to).

So which one is better? That all depends on your business and your goals. Are you looking to maintain full ownership and full control over the business? If so, debt financing is your only real option. Are you worried about the possibility of default and eager for some expert advice along the way? Pursuing equity financing could be better. There’s no single right answer here because no two businesses (or business owners) are the same.