Debt Financing vs. Equity Financing
Why Do Small Businesses Need Financing?
Small businesses, particularly startups, find it difficult to commence operations or even survive without some form of external financing.
This is applicable even to entrepreneurs bootstrapping their ventures, which in other words, is spitting out the funds themselves, even by way of credit cards to get going and survive in the short term.
The good news, however, is that a variety of financing options are available in the market and which range from bank business start up loans, invoice factoring services, to venture capital and crowdfunding. Which then do you select as your most viable option?
What are the Types of Debt Financing?
- Term loans
- Secured lines of credit
- Receivables or invoice financing
- Credit cards
- Merchant cash advances
Debt Financing: An Introduction
Normally, two broad financing categories exist: debt and equity. However, choosing the right option is somewhat confusing as both come with their pros and cons.
Business debt financing is something that’ similar to a loan taken for a college education or to pay off a mortgage. The borrower receives funds from an external source, promising to repay the principal with interest, which is the total “loan cost.”
Subsequently, the borrower makes payments monthly and which includes both the principal and interest. You may also be required to offer the lender some collateral in the form of some movable or immovable assets that he owns.
These include real estate, inventory, insurance policies, accounts receivable, or even machinery, plant and equipment, which the lender can sell off to realize his dues in case the borrower defaults.
However, some alternative financing methods allow borrowers to make payments weekly or to repay a percentage of profits, instead of making fixed payments monthly.
Many small business owners often flip the switch for the SBA or Small Business Administration for conventional business loans. These are available through banking partners that offer relatively lower interest rates with longer repayment terms. However, their approval requirements are more stringent.
Types of Debt Financing
Debt financing is available in multiple forms. These include the following:
These are usually disbursed by banks and/or or alternative lenders. The full capital is provided upfront and repayments are to be made over a pre-determined time period with a fixed or reducing interest rate.
Secured lines of credit
These are also available from financial institutions and/or banks. These are usually a little harder to garner because of their low rates of interest. The borrower gets only the required cash amount at any given point of time.
Receivables or invoice financing
Usually given by financial companies, receivables or invoice financing is about capital disbursement at a discount against any income receivable by the borrower later.
This type of debt financing is available from credit unions, banks, loans and savings institutions for borrowing money, repayable with interest after a certain grace period.
Merchant cash advances
A merchant cash advance is a sort of loan product is given to small businesses that receive the lion’s share of their revenues through credit cards. The lender will take a pre-determined percentage of the borrower’s daily credit card earnings.
When you open the door for equity financing, you are basically selling off a portion of your total holdings in your company to external investors who will be entitled to share its future profits. Equity financing may be obtained in several ways such as through venture capitalists or by equity crowdfunding.
A distinct advantage of equity financing is that business owners opting for it don’t need to repay the loan in regular installments or face the additional burden of high interest rates.
Instead, those who have invested in such companies shall be co-owners with an entitlement to a share of the company’s profits and/or a voting right even on company decisions. This, of course, depends on the terms agreed upon when the equity financing is done.
Equity financing is more popular with venture capitalists and angel investors who keep a close watch on startups that have great growth potential, provided the capital investment is available to them to scale.
A venture capitalist and/or angel investor is often a highly experienced and trained investor who won’t finance just any project that comes his way.
You need to be convinced with solid financials, the economic viability of a service or product that needs financing as also a qualified and experienced management team that will run the business.
Moreover, venture capitalists and angel investors aren’t easily available and need to be contacted with solid references. However, certain accelerator and incubator programs that coach startups to face such investors are now available.
Equity crowdfunding is about small businesses selling tiny portions of their company’s shares multiple investors throughout the state in which they operate. These campaigns, of course, require extensive marketing efforts and groundwork to acquire the required funds. Equity crowdfunding is manned by the dictates of the JOBS Act.
In sum, equity financing is available from the following:
Family & friends
Private investors who put in relatively small amounts of money into a new business for a share of its profits later.
The angel investor
An association or private individual who invests large sums of money usually in a startup or small business with growth potential, with a view to owning a large share of the business later.
These make public investments worth millions of dollars in promising startups only.
How Viable is Equity Financing For Your Business?
Research shows that equity financing works well for innovation and high-risk technology startups that have ample potential to give back substantial returns on investment.
It is also viable for businesses that function in highly cyclical industries where steady cash inflow is often a problem.
However, before investing, a venture capitalist for instance, will have some typical demands on whether the startup has ambitious yet practical plans such as global outreach and/or market domination.
Moreover, any equity financier will definitely go through your business plan with a fine comb for a competent management team, the actual demand for your service or product in the present and future, a pricing and sales strategy that’s clearly defined, your strategies to tackle and beat competition, and, more importantly, your financial projections.
Debt financing usually works well with the hospitality, manufacturing and retail sectors. All that a borrower needs to show is a viable business plan, an acceptable credit score, copies of his or her tax returns and financial statements, sufficient operating history and profits to qualify for a loan.
However, before signing on the dotted line for debt financing, one needs to be sure that they should generate enough revenue in the future to repay the debt.
Advantages of Debt Financing
- For small business owners, debt financing is more easily and widely available in many forms, and its terms are more often than not finite and clear. The business owner, moreover, gets to retain full control of his company as compared to equity financing, which does not allow this to happen.
- Debt financing is available for any kind of business, irrespective of its size.
- Since ownership of the business is fully retained, the business owner does not need to share his or her profits in the long run.
- The time for repayment is pre-defined.
- Interest payable on the loan is deductible from the business’s tax return. This helps shield a part of the business’s income from taxes thus lowering its yearly tax liability. The interest is based on the prime interest rate.
- Loan interest rates are generally lower as compared to equity loans.
Disadvantages of Debt Financing
On the flip side, however, debt financing has its critical disadvantages also. These are as follows:
- Failure to repay loans on time to commercial banks or credit card issuers can ruin your credit rating, making future borrowing difficult or even impossible. Even failure to repay family members and friends stand to strain relationships.
- You stand to lose your personal assets that have been put up as collateral to a commercial bank if the business flops.
- The risk of bankruptcy is always high with debt financing. That’s why calculating the debt to equity ratio is advisable to ascertain your firm’s debt position as compared to its equity.
- Even though a new business may be incorporated, most lenders will still insist that it pledges its personal or business assets as collateral for a loan. Therefore, the business’s failure could ultimately result in the loss of its personal and/or business assets.
- Depending on the loan volume, in debt financing, interest and repayment terms can often be steep. For a borrower to start repaying his first loan installment after the loan has been disbursed could be difficult if his business isn’t on a firm financial footing yet.
- Requires payment of both principal as also interest, irrespective of whether the business is running well or not.
- Since debt is an expense, it prevents the business owner from ploughing back their revenues into the business.
- A lenders may put certain restrictions on your efforts to get financing from other parties or on what you use the loan for.
Advantages of Equity Financing
- The cash available from equity financing may be used for all initial start-up costs, instead of shouldering the burden of large loan repayments to financial institutions, banks, or other individuals. The unwanted debt burden, therefore, doesn’t exist.
- New business owners who prepare a prospectus honestly for their investors and which explains to them clearly that their money could be at risk in their business, will get to know beforehand that if the business fails, their investment too, would be lost.
- Often new investors offer valuable assistance in the early phases that goes a long way in building up the business.
- Even though equity financing is more difficult to get, a new business that scores an investment gets ready capital on hand for scaling up. Moreover, it does not need to start repaying with interest until the business becomes profitable.
- With equity financing, you stand to distribute the entire financial risk among a larger set of people. Moreover, even if you aren’t profiting, the question of paying back doesn’t arise. And should the business fail, nothing needs repayment.
Disadvantages of Equity Financing
- Equity financing stipulates that your investors are actually co-owners of your company, depending on the volume of their investment. That’s why one needs to be careful when selling a portion of the business to outsiders.
- If you relinquish more than 49 percent of the shares, you stand to lose your majority stake and will have less control over the company’s operations. It could also result in your removal from the company’s core management team if the other co-owners think that a leadership change is required.
- Any failure to act in the best interests of your co-owners could expose you to litigation and result in paying heavy compensation or even fines if the court verdict goes against you.
- Going public involves a lot of legal compliance and paperwork and this again requires appointing professionals for handling the same. This could increase your overhead costs substantially. So check out the stipulations of the Securities and Exchange Commission to know how widely you can open up your company to external investors.
- Since you relinquish a part of your business, you lose total controlling power. Your investors now have the right to control key decisions and influence the company’s working culture.
- Keeping investors regularly informed about the day to day activities of the business can be a tedious task and can take up precious man-hours.
- Even though your equity partners usually do not expect a return on their investment for the first three to five years, they often exit after five to seven years.
Lower Financing Cost: Debt Versus Equity
Debt financing is usually available at a lower cost, provided the company is predicted to perform well in the future. For instance, if a small business needs $40,000, it can either opt for a bank loan at say, 10 percent interest rate. On top of this, it can sell a 25 percent stake to an outsider for the same amount.
Now suppose the business earns a profit of $20,000 during the financial year. A bank loan at 10 percent interest would carry an additional debt burden of $4,000, cutting its profits to $16,000. On top of this, equity financing would result in zero debt and without any interest expense, the business owner would, therefore, get to retain 75 percent of the profit that is $15,000 while it’s co-owner would get $ 5,000.
But then again, the advantage offered by a fixed-interest debt may also turn out to be disadvantageous. It becomes a fixed expense and increases the business’s risk. If the business had earned a profit of only $5,000 during the year, debt financing would demand a payment of $4,000 as interest, leaving the owner with a profit of only $1,000.
With equity, however, the interest expense would be eliminated and the business owner with his 75 percent share would get $3,750. Debt financing, therefore, turns out to be more risky for those businesses that fail to generate the required cash because the fixed-cost of debt may not only prove burdensome but fatal, too.
The Bottom Line
The final question that now arises is: Is debt financing more viable than equity financing or vice versa? This depends totally on the type of business you intend having and whether its advantages at all outweigh its risks.
Additional factors include your financial strength, credit standing, potential investors, the final business plan, your tax situation as also the tax liabilities of your investors.
This, therefore, calls for some extensive research on the existing norms in the industry where you function, and steps being taken by your competitors.
It also calls for investigating multiple financial products to finally select the one that suits your needs perfectly. If you consider selling equity, do it in a way that legally allows you to have governing control over your business.
A business can never be totally certain what its revenue earnings will be in future. This obviously gives rise to a certain amount of risk. Thus companies functioning in largely stable industries that have consistent cash inflow opt more for debt equity than their counterparts in risky businesses or even startups.
A new business with a higher degree of uncertainty is generally seen having a hard time getting debt financing, and instead, choose equity to finance their workings. Often a mix of both equity and debt financing determines the business’s final capital cost.
From buying new equipment to building a new manufacturing facility, debt and equity financing give companies working capital to make both small and large expenditures possible. Whether it be issuing a bond or taking out a loan, almost every company engages in some sort of financing.
Take the U.S. stock market for example. The most well-established market for equity securities is estimated to be worth more than 30 trillion dollars. Given that equity and debt financing boasts many derivatives and components, it’s not an easy topic to grasp. To help you understand this complex topic better, check out our list of FAQs below.
A Glance at Debt Financing
When most people think of financing, the first thing that comes to their mind is debt. Be it loans or bonds, both companies and individuals rely on debt when they don’t have sufficient capital on hand. Banks, private investors, and various other investors make their primary source of income by issuing debt.
While loans are the most common forms of debt, there are numerous types with varying degrees of complexity. The below questions will help you get a better grasp of what debt financing is and how it works.
What is debt financing?
How does debt financing work?
What is venture debt financing?
Which is a disadvantage of debt financing?
What is an example of debt financing?
What are the advantages of debt financing?
What is debt financing in business?
What are the risks associated with debt financing?
Is debt financing good or bad?
What are the two sources of debt financing?
What are three general types of debt financing?
What are the major types and uses of debt financing?
What are the five characteristics of long-term debt financing?
What are the four sources of long-term debt financing?
What is debt financing for startups?
What is debt capital financing?
Does financing by debt increase risk?
Why debt financing is good for the economy?
What is commercial debt financing?
How is debt financing important?
How to identify and evaluate sources of debt financing?
What is senior debt financing?
How does a company get debt financing?
A Glance at Equity Financing
The main alternative to debt is equity financing. Unlike debt, equity stake in a company means the investor has ownership interest but isn’t always entitled to business income.
The most popular type of equity financing in today’s market are stocks. An advantage to equity financing is that businesses don’t have to make monthly payments like they do with debt. With that said, equity often comes with less risk. We’ve compiled a list of questions to help you understand the ins and outs of equity financing.
What is meant by equity financing?
Equity financing is when a company gains capital by selling ownership of their company. Some of the most common types of equity financing include stocks, crowdfunding, and investments from friends and family.
What is equity financing and what are its major sources?
What are the different types of equity financing?
Which is an example of equity financing?
How does equity financing work?
What is equity financing examples?
What is equity loan financing?
What is home equity financing?
What is one of the drawbacks of pursuing equity financing?
What documentation is needed to be shown for equity financing?
What is equity financing in a home?
What is equity financing pros and cons?
What would a business plan look like for equity financing?
Do investors prefer equity financing?
Do you have to pay back equity financing?
What are the external sources of equity financing?
Are equity firms same as debt financing?
What type of equity is angel financing?
What do banks require for equity financing?
Accounting for Debt and Equity Financing
Given that there are numerous types of debt and equity instruments, accounting for them can be difficult. Even though both types of financing provide the business with working capital, one is considered a liability (either long-term or short-term), and the other is considered shareholder’s equity. In addition, debt comes with monthly payments on the principal and interest – both a debit to the liability account and interest expense.
Take a look at the below questions to help clear some of your confusion about accounting for debt and equity financing.
How to account for equity financing?
Why equity financing?
Where does debt financing go in income statement?
How to start debt financing?
What is a typical APR for debt financing?
The Role of Tax in Equity and Debt Financing
Both state and federal income taxes play a big role in equity and debt financing. Debt financing comes with major tax incentives when compared to equity. On the other hand, there are some tax benefits that come with unique equity instruments.
These questions will give you a better look at how tax comes into play when a company engages in equity or debt financing.
How does tax equity financing works?
Will tax equity financing be restructured with lower tax rate?
Why is there a tax advantage to debt financing?
Why is debt financing considered a tax shield for companies?
What is tax equity financing?
How does tax equity financing work?
Differentiating Equity vs. Debt Financing
There are several key differences between equity and debt financing. Although both provide working capital to a company, one you have to repay and the other you don’t. Not only are the requirements for each of them different, but the long-term effects and accounting methods are too.
Before diving deeper into the logistics behind each area of financing, you must understand the main differences.
Are stocks equity or debt financing?
Why might a company choose debt over equity financing?
What is equity financing vs debt financing?
Why is debt financing cheaper than equity financing?
What is the difference between equity and debt financing?
What is an advantage of equity financing over debt financing?
Is equity financing better than debt?
Why do companies use equity financing if debt is cheaper?
Do equity options count as debt financing?
Why would a company forgo debt financing over equity?
How does private equity financing work?
What is equity in health care financing?
Hybrid Financing Instruments
To add more complexity to the equation, there are also financing instruments that are a mixture of both debt and equity financing.
Hybrid instruments are sometimes attractive to companies because they get the best of both words. Take a look for yourself and see the hype behind hybrid securities:
What is the best combination of debt and equity financing?
While it varies by each company, convertible bonds are one of the most popular types of hybrid securities. Companies often prefer convertible bonds over conventional bond because they can issue it for a lower coupon rate.
What is convertible debt financing?
What is mezzanine debt financing?
What is mix of debt and equity financing?
Are bonds a form of equity financing?
Do options count as debt financing?
Jason is a Senior Author for SBL. He has been working with small business owners like you for the past ten years. He graduated with an MBA and began a career as an independent financial consultant for small businesses in his state.