The key differences between Debt Financing and Equity Financing
Owning and running a small business is an exciting and rewarding journey for many business owners, although more often than not, the challenging part of this process is finding the right funding to help the business grow and thrive. Funding falls primarily into two categories: "debt financing" (getting a loan) and "equity financing" (selling a share of your business to investors).
In this article, we are going to look at debt vs equity financing, the pros and cons of each and how to figure out which is right for your small business.
What is Debt Financing?
Debt financing is when a business gets a loan from an individual or institution. Most commonly, the loan is provided by a bank, neo-bank or non-bank lender. In return for lending money, lenders become creditors and receive a promise to have the principal of the loan repaid over a set term, with interest payments.
What is Equity Financing?
Simply put, equity financing is the raising of capital through the sale of shares in your business. In equity financing, shareholders gain ownership interests of your business. As such, there are no fixed repayments to be made, since your equity investors will receive a percentage of the profits of the business, according to their shares they hold. Equity financing can range from a few thousand dollars from a private investor, to an initial public offering (IPO) on a stock exchange for billions of dollars.
Why choose Debt Financing?
In general, debt financing is more straightforward than giving away equity in your business. As you can imagine, issuing shares in your business results in the dilution of your ownership interest and determining the value of the equity is not always simple. This also means that you may lose some control over your business. In debt financing, the lender is only entitled to the repayment of the loan (plus interest and fees) and has no claim to future profits of your business.
There are many different types of debt financing available depending on the financing needs of the business and below are three common types of business finance.
- Unsecured Business Loan: If a business is relatively new and doesn't have many business assets to use as security, an unsecured business loan could be the answer. These are often expensive and the repayments aren't very flexible though.
- Equipment Finance: If you are looking to buy a vehicle, machinery or equipment for your business, equipment finance is often the best solution as it allows for the matching of repayments with the revenue the equipment will earn. It is also more cost effective than an unsecured business loan as the lender has the security of the equipment, making it safer for them.
- Invoice Finance: For businesses that sell on credit to other businesses, invoice finance, otherwise known as debtor finance or accounts receivable financing, can be a great solution. Invoice financiers generally advance up to 80% of the value of customer invoices up front, bringing forward the cash flow from unpaid invoices. When the invoices are paid, the loan is repaid and because the accounts receivable ledger is used as security, this is a cheaper form of debt financing than unsecured business loans.
Are there any issues?
Businesses that don't have a track record of profitability and not many business assets (eg. equipment or strong accounts receivable ledgers) can find that unsecured business loans are expensive and inflexible. Although there is a place for these types of business loans, it's often cost effective to move to equipment finance or invoice finance when possible. Another potential issue with debt financing is that the lenders expect borrowers to meet the repayments they are promised so it's important to be reliable and communicate with the lender if you foresee any issues. Otherwise, the lender can act to recover the money they are owed, which can put pressure on the business.
Why choose Equity Financing?
With equity financing, you don’t have debt hanging over you irrespective of whether or not your business is making money. This allows business owners to focus more on running and growing their business. More importantly, bringing in equity partners means that there are others with a vested interest in seeing your company succeed. And, if you’re lucky, some of your equity partners may already be experienced business people who bring with them not only expertise and insightful advice, but also valuable connections for your business.
Equity financing can be beneficial for startups in particular, as businesses often struggle to find alternative methods of funding if they haven't been in business for very long.
Are there any issues?
The above being said, having equity partners can be a blessing or a curse. If an investor is a strong personality with a firm view on how the business should be run, they may want more control and you may have competing ideas. Another negative is that fundraising through equity is a lengthy process from identifying and pitching to investors and then the preparation of legal documents and related paperwork regarding the equity. Lastly, determining the value of a business at which an investor joins can be very difficult. If you sell a share of your business early in its life at a low valuation and it goes on to be hugely successful it can turn out to be a very expensive decision. (Some would say this would be a good problem to have though!)
Debt vs Equity Financing - Which is Best for my small business?
Deciding whether debt financing or equity financing is better for your small business will depend entirely on your business model, how long you have been in business, the purposes of your finance, and your personal preferences.
The best choice of action is to compare your business finance options carefully, and weigh up the pros and cons of each option.
Pros and cons breakdown
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If you think that your business can benefit from Earlypay's modern invoice finance facility and would like to find out more, please contact our team today on 1300 760 205.