What is debt financing and equity financing?

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• Debt financing is when you borrow money and pay it back over time with interest.
• Equity financing is when investors pay you for an ownership stake in your company.
• The type you choose will be determined by the nature of your business and its stage of development.
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When small business owners need to raise capital for their businesses, they have two options: debt financing or equity financing. These are very different approaches to raising funds, and each has its own distinct benefits and drawbacks. Here's a look at how they work, the pros and cons of each, and actionable insights on how to choose the best option for your business. 

Debt financing vs equity financing: At a glance

Whether your business needs money for starting up, scaling, investing in your processes, or anything else, debt financing and equity financing are two viable financing choices.

• Debt financing: This is when you borrow money and pay it back over time with interest. Loans, lines of credit, and bonds are among the most common forms of debt financing.
• Equity financing: This is when you take money from an investor in exchange for an ownership stake in your company. Venture capital, crowdfunding, and initial public offerings (IPOs) are among the most common forms of equity financing. 

What is debt financing?

Raising funds for your business through debt financing involves borrowing money, either from a bank or investors, and paying back the principal plus interest over a set period of time. While this kind of financing can sometimes come with restrictions, it usually allows you to retain full ownership and control of your company.

These are some of the most popular forms of debt financing you can pursue in your quest to raise capital:

Loans

Loans are among the most common forms of debt financing for small businesses. These are available through banks and credit unions, and can be backed the US Small Business Administration (SBA). You designate the amount you need, then the lender determines your creditworthiness and sets the terms, which can vary widely. Your financial health, the principal amount, and the type of collateral you're using all factor into the cost of borrowing. Once you're approved, you receive the funds, then pay the money back with set payments plus interest.

Note: Most SBA loans have a $5 million limit and maximum maturities of 25 years for real estate and 10 years for equipment, working capital, and inventory.

Business lines of credit 

A small business can open a business line of credit and draw from it when funds are needed to expand, supplement cash flow during seasonal slumps, or cover other short-term business expenditures. These lines are usually unsecured, meaning you aren't required to put up collateral. Instead of a large lump sum loan, a business line of credit is a fund you can tap into and pay back as you need it.

Bonds

Bonds allow investors to lend money to businesses. Instead of going to a bank, the business owner sells bonds to investors, agreeing to pay back the face value of the bonds on a specific date and paying the interest at regular intervals along the way, usually once or twice a year. Bonds can be either secured (backed by collateral) or unsecured. Maturities can range anywhere from one year to 30 years, with longer-terms bonds paying higher interest rates.

Quick tip: There are many forms of acceptable collateral. These include property, vehicles, cash accounts, investment portfolios, and insurance policies. You may also be able to use your inventory, equipment, and accounts receivable. 

When is debt financing better than equity financing? 

If your business is growing rapidly and you'll be able to pay back the loan plus interest back and still make money, debt financing is probably a good choice. It's also your best bet when you're comfortable with the risk of losing the collateral you're required to put up. Additionally, if you don't want to share future profits with investors and would rather make a payment on a loan, debt financing is the way to go. 

Maintaining control of your company may be the best reason to choose debt financing, according to Carrie Daniels, a Partner at B2B CFO.

"Debt financing is a preferred method of raising capital for business owners who don't want to give up ownership or try to please investors," Daniels says. "You will likely end up doing both if you opt for equity financing."

Pros

Cons

• You will know up front how it will impact cash flow.

• You maintain full ownership and control of the company, with no outside investors to deal with.

• Interest payments are tax deductible over the life of the loan.

• Consistent payment terms help with budgeting.

• Making payments is required almost immediately.
• You may lose your collateral if you can't pay the loan back.
• The cost of a loan can be expensive, especially if you don't have strong credit.
• Required monthly payments could cause cash-flow issues in your company's slow seasons.

Example of debt financing

Let's say Ashley's WXYZ Company is producing popular products and gaining customers but needs capital to increase their inventory levels in order to deliver timely orders.

Ashley is adamant about maintaining total control over her company. She has excellent credit, so she talks to her lender about a business loan. She chooses a $60,000 loan and a 15-year term. Her credit rating lands her a reasonable fixed 6% interest rate. Ashley puts up her equipment as collateral.

The lender approves her loan and extends her $60,000 in credit. She uses it to expand her inventory levels and, as a result, increases her business by 15%. By paying her monthly payment of $506.00 on time every month, her credit rating, and her collateral, are safe.

"Debt financing is predictable," Daniels explains. "Companies know how much the payments will be every month, so they can plan for the impact on their cash flow." 

What is equity financing?

Equity financing is a completely different way of raising capital from debt financing. Instead of borrowing money and paying it back, you're selling shares in your company to investors who then become part owners. 

How does equity financing work?

To raise capital through equity financing, you first need to find investors who are interested in your business. They would review your financial information, business plan, and may take a tour of your facility. If they decide to fund you, they would give you an agreed-upon amount of money for a stake in your company. The amount you can raise and the percentage of ownership that goes to the investor depends on how much your company is worth. In essence, the investors are paying for a share in your company's future profits.

These are some of the most common ways to raise money through equity financing:

Venture capital

Venture capitalists are individuals or groups of investors who can be good sources for raising capital, especially if other options aren't available to you. They would review the company and, if they believe they could make money off the deal, offer you a cash infusion for a piece of your company. 

Crowdfunding platforms

You can take advantage of the power of the internet and sell small amounts of your company through equity crowdfunding. It's a method of raising capital online where in exchange of backing the company, investors receive a stake in the company proportionate to the amount of money they put into it. Equity crowdfunding can provide access to a much wider group of potential investors than a business might otherwise be able to tap. Some notable equity crowdfunding platforms include AngelList, WeFunder, and StartEngine.

Initial public offerings

As a private company, you can sell shares of your company to investors through an initial public offering of stock, or IPO. Choosing this route means your company would go from "private" to "public."

Note: Investors don't have to be strangers. Your friends, family, and business connections may be potential investors and eager to help you reach your business goals. And, of course, enjoy a healthy return on their investment. 

When is equity financing better than debt financing?

If you're running a startup in a high-growth industry (which is attractive to venture capitalists) and want to scale fast, equity financing may be a better option for you than debt financing. It's also a good option if you find yourself in a position where borrowing money just isn't feasible.

"If a company needs cash and can't qualify for debt financing, equity financing can raise the funds they need," Daniels says. "Otherwise, the business could miss valuable growth opportunities."

Remember, too, that debt financing requires a company to begin paying back the loan almost immediately. Equity financing can support a money-losing company until it starts turning a profit. This is advantageous for startups with stretched cash flow. 

Pros

Cons

• It can raise more capital than debt financing sometimes, which is important for rapid growth.

• It gives you a capital raising option when you don't qualify for a loan. 

• You avoid going into debt.

• You may lose control of part of your company, and dealing with investors can be challenging.
• It can be hard to obtain because you need a strong business plan that impresses investors.
• You will be required to share future profits with investors.

Example of equity financing

Let's say Ashley's WXYZ Company has happy clients and repeat business and needs to increase inventory levels to keep up with the demand. Ashley hasn't been in business long, and her credit is only fair. So she decides to sell 20% of the business to investors to raise capital. 

Ashley finds a group of venture capitalists who are intrigued with her business plan and see an opportunity for it to scale rapidly. They invest money into the business and receive 20% of the shares. Now, they own 20% and Ashley owns 80%. The company is able to invest in the inventory they need, and they increase their business by 50%. Ashley and the venture capitalists receive their portions of the profit. 

The bottom line

Raising capital for your small company is possible with both debt and equity financing. There are several factors to consider when deciding on the best option for your business. By understanding each one thoroughly and the impact of each, you can make the decision that  best drives your long-term business success.