Debt Financing vs. Equity Financing: Finding the Right Fit for Your Business
When it comes to raising funding for your business, most options fall into one of two categories:
Debt financing or equity financing.
While both are powerful tools to help you to reach your goals, they come with different advantages and disadvantages.
Let’s take a look at the pro’s and con’s of both!
A Quick Primer on Debt Financing and Equity Financing
Before we get into the subtler aspects of these two forms of financing, it’s important to highlight a major difference in how they work.
- When you use debt financing to secure funding for your business, you’ll pay back the loan (including interest) using cash flows over a set period.
- When you use equity financing to secure funding for your business, you’re trading a portion of your ownership rights, profits and control of your business to another party for the funds.
With this important distinction out of the way, let’s move on to the comparisons…
Advantages of Debt Financing Compared to Equity Financing
- Using debt financing does not dilute your ownership in the company.
- Once you’ve repaid your loan balance, your relationship with and obligation to your lender ends. There is no claim on future profits or control over how the business is managed. Should you exceed the goals of your financial investment, this means you won’t be sharing the benefits as you would with equity financing.
- Due to the regular payment structure, it’s easier to forecast and account for paying off debt. While variable interest rates might complicate this, it’s still easy to manage than buying out an investor in most cases.
- Debt financing interest is tax deductible. This allows you to lower the overall cost of the loan and limit tax liabilities.
- Obtaining capital through debt financing is often simpler than the paperwork and reporting required for equity financing.
Disadvantages of Debt Financing Compared to Equity Financing
- You must eventually repay the loaned funds using your existing profits and cash flows.
- As debt grows, so does interest costs. If you’re facing a difficult financial period, the costs of maintaining the debt might limit your ability to grow your business and, eventually, lead to insolvency.
- Most debt financing requires a set payment. If your cash flows fluctuate throughout the year, this could lead to issues in making payments.
- As your debt-equity ratio grows, lenders and investors might decline additional funding or label your company as high risk.
- Some lenders require pledging of company or personal assets to secure a debt financing agreement. Should you find yourself unable to repay the loan, the impact could spread into your personal finances and assets.
Advantages of Equity Compared to Debt
- Since you’re not paying interest on the raised capital or making cash payments toward a debt, you’re free to use existing cash flows to grow your business.
- As investors have a stake in the future success of your business, many are happy to share their experience and networking connections. You’re not simply gaining access to someone else’s money—you’re gaining a long-term ally.
- Unless otherwise stipulated in your financing agreement, you’re not required to pay back investments should your business fail.
Disadvantages of Equity Financing Compared to Debt Financing
- Due to the regulations facing investors and the complexity of many equity financing agreements, obtaining an equity financing solution often takes longer than debt financing solutions—such as hard money loans or bridge loans.
- By trading ownership for funding, you’re also trading decision-making power. This means you must consult with your investors before making major decisions. Should they wish to grow your business in a way you don’t like, you might even need to cash out of your own business.
- If you’re only looking to fund a small project, giving up ownership rights is likely not a smart decision. Many investors also have minimum funding levels and want to work with businesses and projects of a certain scale. For these reasons, equity financing might not be an option.
Which Funding Source is Right for Your Goals?
Experts agree that for most businesses, a mix of both equity and debt financing is often ideal. This allows you to keep cash flows clear while maintaining growth. As with many aspects of running a successful business or investment project, it’s about finding the balance that works for your current needs while supporting your future goals.
If you’re looking for ways that debt and equity financing can help your business, UT Financial Services, LLC, has helped clients secure the capital needed to succeed for more than 20 years. Contacting one of our analysts is a simple way to assess the options available to reach your goals. Explain your needs and we’ll scour our extensive networks of financial groups and private lenders to find you the funding you need.
This website and blog is a publication of UT Financial Services, LLC. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed.
Purpose of this blog is to give general education and information about investing and business financing. Information on this website and blog do not involve the rendering of personalized investment advice. No content should not be construed as legal or financial advice.
Consult a professional advisor before implementing any of the options presented.