Though there might be a few exceptions, for the most part external capital will be required in order to start or significantly expand the operations of a business. Debt and equity financing are the two most commonly used methods to raise money for a business.

How Do Debt and Equity Financing Differ

With debt financing, an investor loans a business money which will eventually be repaid along with interest. The investor’s return is fixed and he or she will be repaid regardless if the business realizes a profit or not. However, the investor does not receive an ownership stake in the enterprise.

On the other hand, when a business raises money by issuing equity the investor receives a piece of ownership in the company. Unlike debt financing, the investor is not guaranteed a return. Some of or even the entire principal can be lost. Added to that, no interest is paid on the amount he or she invested. The return on investment for an equity investor is based on the performance of the enterprise. If the business makes a profit the investor will receive a predetermined percentage of the profits realized in perpetuity. Likewise, if the business makes a loss the investor will not receive anything. Although this can be very risky for the financier, it provides the possibility to realize a much larger return than what debt financing could have ever provided. (For more, see: Evaluating a Company's Capital Structure.)

Which Is More Expensive?

Some entrepreneurs prefer to borrow money and make interest payments instead of selling a piece of their company to an outsider. This is understandable as the majority of, if not all, entrepreneurs work really hard on their ventures. Selling a portion of their business, even a minority stake, might make the entrepreneur feel as though he or she is giving away a large amount of what they worked tirelessly on.

Many experts have even said that debt financing is a much cheaper option for entrepreneurs. However, the cheapest option is not always the best deal. A better question to ask should be which funding route is more beneficial. When a business takes on an equity partner, it immediately becomes exposed to a number of benefits that debt financing simply cannot provide. (For more, see: The Real Risks of Entrepreneurship.)

More Fair Reward

The potential returns for shareholders of a business are unlimited. Loans may inject capital into a business, but that is pretty much all a lender brings to the table – money. Most times there is no incentive for a lender to bring any additional value to a business. Whether or not an enterprise is doing well, it will be required to make regular payments to its creditors.

An individual who invests in a business in exchange for an equity stake will usually provide offer help, even if it is just advice, whenever needed. An equity investor is much more involved than a traditional lender. This is because an equity partner only gets paid if the business succeeds.

New Perspectives

In addition to injecting capital, when another person that has skin in the game is brought into a business they also bring their connections and different perspectives. This can be a great way to ensure that an entrepreneur stays focused and makes the best decisions in terms of the direction of the business.

A lender does not get involved with the operations and overall strategy of the business they invest in because they are not given that level of control. This might seem good as an entrepreneur is left to run his or her company in the best way he or she sees fit. However, having only one perspective in a business can be detrimental if the business owner's judgment is clouded. An external party with vested interest can help prevent a company from going down the wrong path. (For more, see: Essential Tips for Would-Be Entrepreneurs.)

Dividend Payments Are Not Mandatory

Businesses that take on debt sacrifice potential growth in some form or another. This is because interest payments take away from a business’s ability to reinvest in its product development, marketing and operations.

Selling equity in your business can be a great way to eliminate the leakage of loan payments. This is especially true for businesses that cannot afford to immediately pay an investor back. In many cases, it can take months until a company is able to generate enough revenue to cover operating expenses much less service debts. Unlike interest payments, dividend distributions to shareholders are not mandatory. In fact, it is typically discouraged to issue a dividend when a company has productive areas where they can allocate those funds to further the company's growth. (For more, see: Why Dividends Matter.)

The Bottom Line

Entrepreneurs who are looking to raise capital for their businesses should consider offering an investor equity instead of taking on debt. Although equity investors take a portion of a company's earnings, unlike debt financiers they only realize a return when the business does well. This gives them more incentives to go the extra mile to help make the business successful. In addition, business owners should not be afraid to sell a piece of their business because third parties can bring many valuable contacts, much needed funds and unique perspectives to the table which can help further business growth. After all, 100% of nothing is still nothing, and 50% of something is a lot more than 100% of nothing.

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