Debt Financing vs. Equity Financing

Financing your business with debt typically means taking out loans or lines of credit from institutions and repaying them with interest. “Interest” is the price you pay to borrow money. It’s usually expressed as a percentage of the amount you borrow. Interest may work differently for different types of financing tools.

Lenders typically assess your business’s creditworthiness before offering a loan or line of credit. Each lender has unique priorities, but most use the five Cs of credit—character, conditions, collateral, capital, and capacity—to determine eligibility and make offers.

Debts may be secured, meaning they require collateral, or unsecured, meaning they don’t require collateral. Secured debts tend to come with lower interest rates than unsecured debts. However, they also come with added risk, as failure to repay your loan according to its terms could lead to the seizure of your collateral.

Types of debt financing

• Small business loans — Are usually a type of term loan tailored to unique business needs. Each lender pays out a small business loan as a lump sum, which your business repays in monthly installments over a set term, with interest. Typically, term loans come with predictable monthly payments, making them easy to budget.
• Business credit cards — Function like personal credit cards. Lenders offer you a credit limit, and you can use your card as needed within that limit. If you carry a balance from month to month, you may owe interest. Business credit cards often come with perks and may be easier to qualify for than a business loan. However, debt may quickly pile up.
• Business lines of credit — Work similarly to credit cards—lenders approve you for a set limit. They’re a flexible option that could help with ongoing needs like working capital.
• Family or friends — May lend you money to help your business succeed. While this option could help you avoid extra paperwork and preserve your credit score, it comes with a high degree of personal risk. Delayed or missed repayments could harm your relationships.

Advantages of debt financing

• Debt financing allows business owners to retain full ownership and control of their company.
• Some interest payments on debts are tax-deductible, which can reduce your business’s tax burden.
• Debt financing allows you to keep your business profits instead of sharing them with investors.
• Debt can provide the necessary capital to invest in growth opportunities, such as expanding operations, purchasing new equipment, or acquiring another firm. This can accelerate business growth and increase profitability.

Equity financing means raising capital for your business by selling shares, which represent portions of ownership. Unlike debt financing, equity financing doesn’t require you to repay the funds you raise. However, investors typically receive a percentage of your profits and some decision-making authority. To remove investors, you usually have to pay a high price to buy them out.

While credit may play a small role in some investors’ decision-making, equity financing depends more on your business’s potential. Investors may want to take a gamble on your business if they foresee major returns on their investments.

Each investor makes decisions differently, but many focus on your character as a business owner, your business plan, financial forecasting, and your company’s overall standing. Those factors all affect the viability of investments. Securing equity financing often involves seeking out investment opportunities and pitching your business, with an emphasis on growth.

Types of equity financing

• Angel investors — Individuals who invest their own money into rising startups are called “angel investors.” In addition to pursuing businesses with extremely high earning potential, angel investors may focus on companies that fall into one of their interests. For example, an angel investor who enjoys fine-dining experiences may build an investment portfolio of gastronomic startups and restaurants.
• Venture capital investors — Venture capital (VC) firms identify promising businesses and invest in them from an existing pool of money. While VC could inject significant funding into your business, that funding usually requires a meaningful stake in the company. Individual venture capital investors typically expect a seat on the company’s board of directors and to have a voice in the direction the business takes.
• Equity crowdfunds — Small business owners who feel uncertain about pitching directly to investors may instead set up a profile on an equity crowdfunding platform. There, potential investors could view your business information and request a share. These platforms may charge a fee, but they offer valuable exposure.
• Friends, family, and colleagues — You don’t necessarily have to rely on corporate investors alone to purchase stakes in your business. The people in your community—friends, family, neighbors, and colleagues—may be interested in supporting your company with an investment. Keep in mind, however, that seeking investments from people you know personally may strain your relationships.

Pros of equity financing

• Your business doesn’t have to repay investments you receive through equity financing.
• Equity financing doesn’t require a credit check. While investors typically consider your overall financial standing, your business doesn’t have to meet specific credit requirements.
• Investors may bring unique expertise and insight to your business operations, setting you up for success. Working with investors may also give you access to a new professional network.
• Having more equity investors in your company dilutes risk. That means if your business does not perform well, you share the losses with each partial owner instead of absorbing all the losses.

Cons of equity financing

• Selling shares in your company means relinquishing some decision-making power to investors. You may have to navigate conflict and compromise on some of your business aspirations to fulfill the wishes of your investors.
• Investors receive a portion of your business profits. Typically, those returns come from dividends or capital gains. The percentage of revenue you could either pay yourself or reinvest in the company shrinks with every new investor.
• Raising equity can be a time-consuming and expensive process. It involves legal fees, compliance with regulatory requirements, and significant effort to pitch and negotiate with potential investors. Seeking investors may detract from the time you spend pursuing your business goals.
• Equity investors usually expect high returns on their investments. That means your business may fall under pressure to grow quickly. This pressure could impact your aspirations for your business and may force you to take on more risk for immediate returns.

Your business may use both equity and debt financing at various times to meet different needs. The best option for you depends on your organization’s strategic goals and financial circumstances.

Equity financing may best suit startups and new businesses with limited cash and assets but high growth potential. Through equity financing, your business may access the funds it needs without taking on debt that could have a lasting impact. Plus, the expertise and networking opportunities that investors may bring could give new businesses an early boost.

Debt financing, on the other hand, may be the best choice for more established businesses with reliable cash flow. These organizations could leverage their stability to obtain favorable borrowing terms without sacrificing control over the company’s trajectory. Loans may also be the best tools for specific business needs with predictable revenues. For example, a loan is probably the best option if your company requires funds quickly to replace a piece of equipment. Likewise, debt financing is typically the best choice for debt consolidation.

While these general guidelines may inform your financing choices, remember that many factors may influence your decision. Your unique business goals, industry conditions, and financial standing determine the best option.

A business loan from BHG Financial could help your business reach the next step, whether that’s expanding into new markets, acquiring another business, or launching a new venture. With up to $500,000^{1, 2} in flexible financing, you could expand operations and supplement working capital. Plus, with terms of up to 12 years,¹ our fixed monthly payments shouldn’t strain your budget. Your time is precious, so loan applications with BHG Financial don’t demand hours of paperwork. Instead, you can take advantage of a hassle-free lending process and receive funds in as few as three days³ after approval.

What is the difference between debt financing and equity financing?

Debt financing involves borrowing money from a lender and repaying it with interest, while equity financing involves selling partial ownership of a company in exchange for financial investment.

Why would a business choose debt financing over equity financing?

Debt financing comes with some distinct advantages over equity financing. Notably, debt financing doesn’t require businesses to sacrifice any ownership over the company. Plus, equity financing requires businesses to share profits with investors, which could cut into the operating budget.

Is debt financing riskier than equity financing?

Debt financing is considered less risky for lenders. For businesses, debt financing can be safer if large scale growth is anticipated. The best option for both the business and lender depends entirely on the situation.