What is the Difference Between Debt and Equity Financing?

By: First Union | Date:

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What is the Difference Between Debt and Equity Financing?

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When exploring financing, as a small business owner you will probably look at both debt financing (taking out a loan/) or going the equity route (looking into getting an investor/). If you aren't sure which makes the most sense for your company, keep reading to learn a little more about the pros and cons of each.

What is Debt Financing?

Basically, when we talk about debt financing, we are talking about money borrowed from some type of lender that ultimately needs to be paid back. And usually, there is interest on top of the repayment amount.

With debt financing, you almost always get to decide how the funds will be spent, toward what projects the cash will go—and while yes, some lenders may have a few restrictions, your hands aren't tied by investors. Prime examples of this type of financing include: bank loans, lines of credit, SBA backed loans and business credit cards.

When exploring debt financing options, make sure you do your research. Understand what is associated with each loan type, and find the terms that work for your company's needs. For example, if you're in need of increased cash flow, your best bet might be a line of credit versus something like a short term loan.

Some of the Advantages of Debt Financing

Debt financing is definitely the more popular option for small businesses in need of cash for various projects. In 2017, small businesses across the country borrowed over 600 billion in this type of financing. As such, it is important to grasp the pros and cons of debt financing before diving in. Some of the advantages of this type of funding:

  • It doesn't matter what size your business is, both large and small companies have access to this type of financing.

  • The lenders don't own any equity in your business; in other words, you still maintain total control.

  • Your lender will not be able to claim any stake in future profits that your company makes.

  • Depending on the lender you work with, financing can be available in as little as 1-2 days.

  • There are no reports to file, nor shareholder meetings to run.

  • The interest payments on your loans are usually tax deductible.

  • With debt financing, you have the ability to build up your business credit.

Some of the Disadvantages of Debt Financing

With debt financing, there are financials and other such documentation that need to be submitted. This, in turn, can take some time, and if you're not an accountant, some of it can be over your head depending on how complex your company structure is. Some other cons to consider:

  • You have to first be qualified for the loan, meaning, you need to prove to the lender that you are capable of repayment in a timely manner.

  • If your FICO is low or your financials aren't where they need to be you could get rejected.

  • You may have to put up collateral depending on the lender and loan type.

  • If you default on your loan you could be faced with having to liquidate assets.

  • Even if you are going through a slower time, you still have to make those payments.

  • The debt-to-equity ratio will play a big role in determining whether or not you qualify.

  • You do have to use the revenue to pay your debt. If your debt gets too high, you could thus be putting yourself in a bad position.

What is Equity Financing?

Equity financing, on the other hand, is when you exchange shares of the company for invested capital. This you can then use for your business costs and things such as expansion projects. Some examples of equity financing include: angel investors, crowdfunding, taking on a partner and venture capitalists.

Basically, with this type of financing, you're going outside the company to look for those who wish to invest. You are in essence selling equity in the company to get money to operate.

Generally, if a business is looking for investors their long term plans involve major expansion into a globally known brand.

Some of the Advantages of Equity Financing

Selling off pieces of your company in exchange for money does have good and bad sides to it. Before going this route consider the following carefully. Some advantages include:

  • If your business does go under, you don't necessarily have to pay the investors back.

  • Some investors really do serve as great mentors as they might have ample experience in your industry.

  • You don't have to pay interest and when you make a profit it doesn't have to go toward debt repayment.

  • Most often, an investor will not ask you to put down collateral.

  • For those who invest, they usually take a big picture approach—meaning they are not looking for an immediate return.

Some of the Disadvantages of Equity Financing

Again, you need to weigh all options and explore all facets of equity financing before moving forward. Disadvantages include:

  • Generally, it is only for large amounts of capital.

  • You will have to generate a thorough business plan to present to investors.

  • The process of finding and being approved by investors can seem slow and tedious.

  • You might have to relinquish some control in terms of your company.

  • As they are looking at the long term and generating profits down the road, the investors may lack a day to day operational vision for the company.

  • In certain circumstances, the investors can force you to give up your rights and essentially cash out.

  • When selling the company, you may have to give up a far more significant share of the profit from the sale than you would have you taken out a loan.

Final Thoughts

As with anything, it is very important to consider both financing options from all angles before choosing which one is best for you. Consulting with an expert such as a business attorney or accountant might make sense before taking such a big step. The ultimate goal, of course, is to ensure that your company is financially stable and poised for long term success.

At First Union, we love seeing businesses grow and thrive. We offer many loan options if your business is in need of funding. Also, we love to advise business owners if they are in search of advice. Call today to find out how we can help you!

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