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Every business requires capital in order to scale its operations.
Every business also has multiple financing choices to secure this capital.
Are you currently in the process of weighing your financing options? If so, let’s look at debt vs equity financing, their pros and cons, and which is the best choice for your business.
What is Debt Financing?
Aptly named, debt financing is the act of raising money by selling debt instruments. For most small businesses, this includes loans and credit cards.
More sophisticated debt instruments include corporate bonds or bills.
Debt financing is one of the most common ways businesses acquire the funding they need to grow and expand. This is especially crucial for businesses that are just starting out.
If you have personal loans or credit cards, you’re familiar with how the process works.
You get lent money. In return, you promise to pay back the principal with interest and fees to be paid back at a later date.
You generally need good credit, revenue, and/or collateral to qualify for debt financing. The interest rates that you pay are determined by your risk of default and current market rates.
If you’re considered a riskier business to invest in, your interest rates will naturally be higher. For lenders, the incentive comes in the form of higher interest rates. They also have a bigger claim to liquidated assets should your business go bankrupt.
What is Equity Financing?
Companies who use equity financing do so through selling company shares.
Equity financing is most often employed by companies like startups that need to pay bills or fund projects.
While common stock is the most common form of stock we envision being sold, it’s not the only one.
Some other forms of equity in equity financing include preferred stock and stock warrants. The type of equity sold will depend on where a business is in its journey.
Companies interested in equity financing may also choose to approach different investors. (This includes different types of investment models as well.)
These often include:
- Individual investors– family and friends fall usually under this group.
- Angel investors– they fund businesses early on while also offering guidance and support.
- Venture capitalists– they can invest large amounts and typically take a hands-on role in the business. They only invest in high-growth companies, just as tech startups.
- Crowdfunding- which uses available platforms to drive funding for a certain cause or purpose.
Pros & Cons of Debt Financing
Every financing model comes with its own set of unique advantages and disadvantages.
Understanding these pros and cons is critical to selecting the right financing model for your company.
So, what are the pros and cons of debt financing?
Pros of Debt Financing:
- Debt financing allows businesses to access the capital they need for growth. While there are other methods, debt financing is one viable solution that’s easily understood.
- Debt financing is often less expensive in comparison to equity financing.
- Equity financing requires you to relinquish some control over your business. Meanwhile, debt financing allows you to retain full control while also receiving funding.
Cons of Debt Financing:
- Debt financing requires you to pay interest on the principal. For businesses with poor credit, this can be a substantial amount to pay back.
- Additionally, not all businesses may have reliable streams of income. If your income is inconsistent, it can be difficult to create a financial plan of action. This can spell disaster should you come up short when the time comes to pay back investors.
- You have to pay your debts back regardless of whether or not you performed as expected. This is why debt financing is risky, not only for investors but for businesses as well.
Take these considerations into mind if you’re considering the debt financing model for your company. If you have a trucking company, you can even check out our Best Factoring Companies For Trucking article for options.
Pros & Cons of Equity Financing
Equity financing may often look like a more desirable option. However, there are still upsides and downsides to the model. Here’s what you need to keep in mind with equity financing.
Pros of Equity Financing:
- Debt financing requires you to pay back capital plus interest. Equity financing allows you to avoid having to pay back your funding. This can be a major upside for those looking to avoid debt entirely.
- Debt-free funding isn’t the only advantage of this model. Angel investors are willing to provide their expertise and support to help your business thrive.
- You have multiple forms of equity that you can leverage throughout your business’s journey. This offers support no matter where you may currently be.
Cons of Equity Financing:
- As with debt financing, there has to be an incentive for investors to fund your company. In this instance, they’re receiving a stake in your business. If you’re not ready to relinquish control, this can be a disadvantage.
- You have to share your profits, which is fine if you’re in a profitable state. If you’re struggling, it can be a loss of much-needed resources. This can also result in equity financing becoming a more expensive model for business funding.
- You won’t receive the same tax benefits that you might receive with debt financing. This can result in further payments that take essential profits away from your company.
When To Choose Debt Financing vs. Equity Financing
There’s a great deal of consideration when examining debt vs equity financing. While both can serve as a source for funding, only one may be right for your business.
How do you know which one to choose?
Here are some questions to ask yourself so you’re confident in making the right decision.
- What are my priorities?: Are you looking to reduce costs while receiving funding? Do you want the extra support of experts as your business grows? Consider your priorities and which model helps you best meet those expectations.
- How stable is my business’s performance?: Performance matters in both debt financing and equity financing. However, it may matter more in regard to loan repayments. Consider performance when evaluating debt vs equity financing.
- Where is my business currently?: Risk is what matters most. If you have inconsistent income but a high growth potential, you may need equity financing. If you’re established and are comfortable carrying debt, debt financing may be a better option.
The reality is that no two businesses are alike. The factors that determine which financing model is right for you will vary depending on where your business is.
Consider the above so that you don’t spend time leveraging the wrong financing model.
Understanding your financing options is critical to growing your company effectively.
Two choices you have at your disposal include debt and equity financing.
If you’re at the point in your business where it’s time to finance, use the guide above to learn more about debt vs equity financing. It can mean the difference between successful scaling and early closure!
Dylan Buckley is a freelance finance writer and editor with 7 years of professional experience. Specializing in personal finance, cryptocurrency investments, and Fintech, Dylan is deeply passionate about creating content that helps readers make informed, confident financial decisions. He studied finance in college and maintains a credit score over 780.