Debt Financing Vs. Equity Financing – The Pros and The Cons

one way/another way sign post – Debt Financing Vs. Equity Financing – The Pros and The Cons

Let’s begin by stating a simple truth – businesses need finance to grow.

In an ideal world, this finance would be taken from the business’s very own booming profits, and growth would be self-perpetuated forever more. Unfortunately, however, this is the real world that we find ourselves in, and the real business world at that, where the ability to create the sort of short-term profits to secure long-term growth is rarely ideal.

In recent times, acquiring finance has become somewhat of challenge for the SME. Traditionally, businesses would turn to their bank when the time came to either begin a new venture or seek funds for expansion. But, in the wake of the economic downturn, banks have been failing SMEs left, right and centre, strapped, as they now are, with burdensome regulations that prevent them from lending like they used to. Indeed, as many as 50% of first time SME borrowers have been rejected finance by their bank, according to the UK Department For Business Innovation and Skills.

Thankfully, there is no shortage of alternative finance options these days, and in fact, these so-called alternatives are often better than their traditional counterparts. However, it goes without saying that funding is very rarely free – in exchange for the capital put forward by the backer, either interest will be expected on the return, or otherwise a percentage share in the business. And so, the business that seeks out alternative funding will essentially be met with a choice of two options – equity financing and debt financing.

But what are the differences between these two funding methods, and which is most suitable for your business?

Debt Financing Vs. Equity Financing

The simplest way to understand the basic differences between debt and equity finance is to perceive of the differences between a lender and an investor.

A lender will stump up hard capital, which he/she will expect, over an agreed timeframe, to receive back in full plus interest. The relationship between lender and borrower is limited to this arrangement, and will end the moment the final payment is made. This is what is meant by debt financing.

An investor, on the other hand, will buy a stake in the borrowing business as a percentage, and will then receive a matching percentage of all profits the business generates over its lifetime. This is what is meant by equity financing.  

In a nutshell, those are the differences.

However, there are various types of both debt and equity financing. Let’s explore.

Types of Debt Financing

Loans from Banks, Credit Unions or Alternative Lenders

This is debt financing in its simplest form – a business borrows money from a bank or alternative lender, and pays the loan back over time plus interest.

Loans from Friends, Relatives or Your Personal Savings

Finance rarely comes for free, but businesses may be able to obtain loans from friends or relatives at significantly cheaper rates than if they went through a bank or alternative lender. Terms are also likely to be more flexible.

Alternatively, if a business owner has personal savings or even a pension fund, he/she may wish to borrow money from him/herself to acquire the short-term finance needed for the long-term growth of the business.

Credit Cards and Overdrafts

A business may set up an overdraft agreement with its bank, which will establish a limit to the account, and the business owner may withdraw funds up to that limit. Interest will need to be paid on the overdraft. (It must be noted, however, that banks are currently cutting funds from SME overdrafts at an alarming rate, so caution is advised if relying on overdraft lines of credit).

The business may also use credit cards for similar purposes with similar terms.

Trade Credit

Businesses may be able to set up trade credit agreements with their suppliers. The business buys stock from its supplier for sale, but, instead of demanding immediate payment, the supplier extends the payment terms, giving the business a chance to use revenue generated towards the purchase.

Factoring

This is when a business essentially sells its accounts receivable at a discount to a third party in exchange for cash up front, and the factoring company then collects payment from the customer. The factoring company often won’t take full responsibility for the debt, however. If the customer fails to pay, then the business must still pay back the loan to the factoring company, often with quite high interest.

Is Debt Financing the Right Move for Your Business?

As with everything, there are pros and cons to debt financing.

One advantage is that, provided the borrowing business can prove profitability, any business, no matter its size, can apply for debt finance from banks, credit unions or traditional lenders. Another element on the pro list is that with debt financing the business retains complete ownership, meaning that there will be no sharing of profits in the long term. Repayments of loans are also predictable, and, over the long-term, interest rates on loans will typically be lower than the return on equity investments.

However, there are some cons to consider. Taking on debt is a risk – no matter if business is good or bad, repayments still have to be made, eating into revenue generated, which could otherwise be used to fund growth. Furthermore, if the business finds itself in a position where it cannot pay back the loan, then the cost will be the business’s assets which it will have pledged as collateral before the loan was agreed. Lenders may also restrict what the business may spend the loan on, and also whether the business can seek further funding from elsewhere. 

Types of Equity Financing

Angel Investors

Angel investors are generally private individuals or associations. They often invest large sums of money into a business in return for an ownership percentage, which can often be quite high. However, it is in the angel investor’s interest that the business succeeds, and therefore he or she will often play an active role in achieving this. Therefore, when utilising the services of an angel investor, it is typically more than capital that you’re paying for, but an extra brain and pair of hands as well. 

Friends and Family

Businesses may sometimes turn to friends and family for investment, though this will typically be for small amounts of money in exchange for a small share of the profits.

Venture Capital Firms

Venture capital firms make a living out of investing in businesses, but they will be looking for a high rate of return. A business will give up a portion of its ownership to the firm, which will normally insist on having a representative placed on the business’s board of directors. 

Is Equity Financing the Right Move for Your Business?

Once again we have pros and cons.

Perhaps the most obvious advantage is the fact that the business that chooses equity financing will take on no debt, which means that revenues will not ever be used to repay loans. Indeed, for brand new businesses which have yet to even start generating any revenue, or those which have yet started to turn profit, equity financing may be the only option. In this case, it will be the investor who takes on nearly all of the risk, and will therefore be driven to ensure that the business succeeds.

The cons of equity financing, however, are just as many. Acquiring investment in the first place is not a simple procedure and will take up many hours of the business owner’s time. Investors will scrupulously scrutinise business plans, pick holes in them, and will require to see a demonstrable market need for the proposed product or services. Once investment is acquired, they will then demand regular and thorough reports on an ongoing basis, which again will take up many man-hours. Furthermore, by giving up part ownership of the business, not only will profits be sacrificed, but also control over key business decisions and company culture.

Final Word

Deciding whether debt or equity financing is most suited to your business will inevitably require some research on your part, but the most appropriate method should reveal itself soon enough.

Startups, and particularly technology startups with aspirations for market domination or global reach, will typically be best suited for equity financing from an experienced investor who can open doors in the business world that would otherwise remain shut.

Established business, especially those in traditional sectors such as manufacturing, retail and hospitality, are often more suited to benefit from debt financing. However, before you commit to taking on new debt, you will need to prove to yourself as much as the lender that enough revenue will be generated to pay back the loan, or else you may risk (depending on the size of the loan) losing everything. 

In the end, it all boils down to doing your homework and making the smart decision to ensure your business’s survival in an increasingly competitive world.

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