Debt vs equity financing: Which is the best fund raising option for your small business in the short or long term? Here is a detailed comparison to help you. When it comes to raising money for your new business, you have two options to exploit. The first is to borrow money (debt financing), and the second is to sell ownership interests to investors (equity financing).
However, deciding between both options is a challenge for virtually all entrepreneurs that need seed capital to start a new business or expand an existing one. Why? The reason is because choosing a source of capital is a decision that will have a long-term influence (positive or negative) on your business.
In this chapter, you will learn the advantages and disadvantages of debt financing and equity financing, and you will be able to determine which funding option is best for your business.
Now before thinking of obtaining finance for your business, you need to spend some time developing a business plan. Why you need to write a business plan before anything else and how to craft an excellent plan have been explained in the previous chapter. Only after completing your business plan should you go forward with financing plans for your business. Now, let’s get back to the two main business financing options.
What is Debt Financing?
Debt financing simply involves borrowing money from individuals, banks, or other finance institutions to fund your business. This money is repaid over time along with some interest. If you would be going in the way of debt financing, you should try to start from family and friends because they would most likely loan you the necessary funds at lower interest rates and better repayment terms.
If the funds still don’t add up, then you can approach a commercial lender who gives loans to small business owners. In fact, these may be the only debt financing options you have if you are just starting a new business, as most banks and other credit-issuing institutions don’t give loans to finance new business.
However, if you are trying to expand an already existing business, then you have brighter chances of getting loans from banks and other finance institutions; provided your business has reached certain milestones as specified by the institution.
Sources of Debt Financing
Below is a list of the various sources of debt capital:
- Commercial banks
- Asset-based commercial lenders
- Commercial finance companies
- Savings and loan associations
- Stock brokerage houses
- Insurance companies
- Cooperative thrift and credit unions
- Bonds
- Private placements
- Small business investment companies (SBICs)
- Small business lending companies (SBLCs)
- Federal, state and local government loan programs
What is Equity Financing?
Equity financing involves bringing in investors or partners who provide capital in exchange for a share of the ownership of your business. So, if you have friends, family, or other people who want to invest in your business outright (become part owners) instead of simply lending you money, you can raise money for your small business this way, too.
These investors or partners generally invest because they expect to make a profit when the business becomes successful. However, it is important you know that allowing people (called equity investors) to own part of your business comes with its own set of advantages and disadvantages.
Sources of Equity Financing
- Friends and family members
- Angel investors
- Venture capital firms
- Public stock sale
Debt Financing vs Equity Financing: Which is the Best for your Business?
Well, I don’t think there’s a definite answer to this question because the choice or source of finance you choose depends on your needs and your business capacity to deliver. If you are trying to finance a startup venture, it is better to seek equity investments, because you generally only have to repay investors if the business turns a profit. And if the business tanks, you don’t have to repay.
For ongoing needs like working capital funds, loans are better for businesses with established and predictable cash flow that allows for realistic repayment schedules, and for businesses that can obtain the loan without jeopardizing personal assets.
Because each type of financing has its own appeal, some entrepreneurs opt for a blend of both equity and debt financing to meet their needs when expanding a business. The two forms of financing together can work well to reduce the downsides of each. The right ratio will vary according to your type of business, cash flow, profits and the amount of money you need to expand your business.
Lastly, it is important that you look at the benefits of each to see which may most help your business, and compare the typical debt-to-equity ratios of other businesses in your industry when deciding what type of financing to seek.