Equity Financing vs. Debt Financing: An Overview
To raise capital for business needs, companies primarily have two types of financing as an option: equity financing and debt financing. Most companies use a combination of debt and equity financing, but there are some distinct advantages to both. Principal among them is that equity financing carries no repayment obligation and provides extra working capital that can be used to grow a business. Debt financing on the other hand does not require giving up a portion of ownership.
Companies usually have a choice as to whether to seek debt or equity financing. The choice often depends upon which source of funding is most easily accessible for the company, its cash flow, and how important maintaining control of the company is to its principal owners. The debt-to-equity ratio shows how much of a company's financing is proportionately provided by debt and equity.
- There are two types of financing available to a company when it needs to raise capital: equity financing and debt financing.
- Debt financing involves the borrowing of money whereas equity financing involves selling a portion of equity in the company.
- The main advantage of equity financing is that there is no obligation to repay the money acquired through it.
- Equity financing places no additional financial burden on the company, however, the downside can be quite large.
- The main advantage of debt financing is that a business owner does not give up any control of the business as they do with equity financing.
Equity financing involves selling a portion of a company's equity in return for capital. For example, the owner of Company ABC might need to raise capital to fund business expansion. The owner decides to give up 10% of ownership in the company and sell it to an investor in return for capital. That investor now owns 10% of the company and has a voice in all business decisions going forward.
The main advantage of equity financing is that there is no obligation to repay the money acquired through it. Of course, a company's owners want it to be successful and provide the equity investors with a good return on their investment, but without required payments or interest charges, as is the case with debt financing.
Equity financing places no additional financial burden on the company. Since there are no required monthly payments associated with equity financing, the company has more capital available to invest in growing the business. But that doesn't mean there's no downside to equity financing.
In fact, the downside is quite large. In order to gain funding, you will have to give the investor a percentage of your company. You will have to share your profits and consult with your new partners any time you make decisions affecting the company. The only way to remove investors is to buy them out, but that will likely be more expensive than the money they originally gave you.
Debt financing involves the borrowing of money and paying it back with interest. The most common form of debt financing is a loan. Debt financing sometimes comes with restrictions on the company's activities that may prevent it from taking advantage of opportunities outside the realm of its core business. Creditors look favorably upon a relatively low debt-to-equity ratio, which benefits the company if it needs to access additional debt financing in the future.
The advantages of debt financing are numerous. First, the lender has no control over your business. Once you pay the loan back, your relationship with the financier ends. Next, the interest you pay is tax-deductible. Finally, it is easy to forecast expenses because loan payments do not fluctuate.
The downside to debt financing is very real to anybody who has debt. Debt is a bet on your future ability to pay back the loan.
What if your company hits hard times or the economy, once again, experiences a meltdown? What if your business does not grow as fast or as well as you expected? Debt is an expense and you have to pay expenses on a regular schedule. This could put a damper on your company's ability to grow.
Finally, although you may be a limited liability company (LLC) or other business entity that provides some separation between the company and personal funds, the lender may still require you to guarantee the loan with your family's financial assets. If you think debt financing is right for you, the U.S. Small Business Administration (SBA) works with select banks to offer a guaranteed loan program that makes it easier for small businesses to secure funding.
Equity Financing vs. Debt Financing Example
Company ABC is looking to expand its business by building new factories and purchasing new equipment. It determines that it needs to raise $50 million in capital to fund its growth.
To obtain this capital, Company ABC decides it will do so through a combination of equity financing and debt financing. For the equity financing component, it sells a 15% equity stake in its business to a private investor in return for $20 million in capital. For the debt financing component, it obtains a business loan from a bank in the amount of $30 million, with an interest rate of 3%. The loan must be paid back in three years.
There could be many different combinations with the above example that would result in different outcomes. For example, if Company ABC decided to raise capital with just equity financing, the owners would have to give up more ownership, reducing their share of future profits and decision-making power.
Conversely, if they decided to use only debt financing, their monthly expenses would be higher, leaving less cash on hand to use for other purposes, as well as a larger debt burden that it would have to pay back with interest. Businesses must determine which option or combination is the best for them.
Choosing which one works for you is dependent on several factors such as your current profitability, future profitability, reliance on ownership and control, and whether you can qualify for one or the other. The different types and sources for each type of financing are described in more detail below.
Some sources of debt financing are:
- Term loans
- Business lines of credit
- Invoice factoring
- Business credit cards
- Personal loans, usually from a family or friend
- Peer-to-peer lending services
- SBA loans
The ability to secure debt financing is largely based on your existing financials and creditworthiness.
Some sources of equity financing are:
- Angel investors
- Venture capital firms
- Corporate investors
- Listing on an exchange with an initial public offering (IPO)
Securing equity financing can be a simpler process than debt financing, but you need to have an extremely attractive product or financial projections, as well as being able to surrender a portion of your company and oftentimes a good amount of control.
Why Would a Company Choose Debt Over Equity Financing?
A company would choose debt financing over equity financing if it doesn't want to surrender any part of its company. A company that believes in its financials would not want to miss on the profits they would have to pass to shareholders if they assigned someone else equity.
Is Debt Cheaper Than Equity?
Depending on your business and how well it performs, debt can be cheaper than equity, but the opposite is also true. If your business turns no profit and you close, then in essence your equity financing costs you nothing. If you take out a small business loan via debt financing and you turn no profit, you still need to pay back the loan plus interest. In this scenario, debt financing costs more. However, if your company sells for millions of dollars, the amount you pay shareholders could be much more than if you had kept that ownership and simply paid a loan. Each circumstance is different.
Is Debt Financing or Equity Financing Riskier?
It depends. Debt financing can be riskier if you are not profitable as there will be loan pressure from your lenders. However, equity financing can be risky if your investors expect you to turn a healthy profit, which they often do. If they are unhappy, they could try and negotiate for cheaper equity or divest altogether.
The Bottom Line
Debt and equity financing are ways that businesses acquire necessary funding. Which one you need depends on your business goals, tolerance for risk, and need for control. Many businesses in the startup stage will pursue equity financing, while those already established and those who have no problem with debt and possess a strong credit score might pursue traditional debt financing types like small business loans.