Curious about a better future with complete control of my life, I always ask people what they prefer as a lifetime profession. The answer, almost all the time, is owning a business. Business is the only true independence. But setting up a business that can last a lifetime needs many things, and an influx of money is crucial. To grow businesses, owners usually depend on two types of sources to overcome their capital needs: Debt financing vs Equity financing. Whether to opt for debt vs equity financing depends on factors such as how a business owner would rather pay for financing, how fast they need the money, or if they are ready to let go of control over the business.

 

What is the difference between Debt financing and Equity Financing?

Debt Financing

Debt financing is issuing bonds to grow a business or, in simple words, is a term used to loan or borrow money from an entity outside the company. In debt financing, the owners are bound to start paying a specific amount of money to the lender with a decided interest, even if they haven’t made their first sale. Some of the significant sources of debt financing are stated as follows;

 

– 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

 

Pros of Debt Financing

Following are some prominent pros/advantages of debt financing. 

 

1) Retain Control

One of the most admired benefits of debt financing is total control over the operations of your business. The lenders have no say in your company policies and other management. You are the sole decisionmaker here, and the contract ends once the debt is paid in full. 

2) Tax Advantage

The amount that you pay in interest does not fall under the tree of tax and, therefore, effectively reduces your net obligations. 

3) Easier Planning

In debt financing, you have a clear idea of the coupons and interest amount you must pay every month. This prior knowledge makes it easier for the business planner to develop effective strategies. 

 

Cons of Debt Financing

Let us have a look at the cons of debt financing.

1) Qualification Requirements

Debt financing coincides with a good credit score. Therefore, you should have a good-to-excellent credit score to qualify for financing. 

2) Discipline

To be in the good books of potential investors, your business needs discipline regarding repayments and financial management. 

3) Collateral

The moment you guarantee the lender about the repayments, you put your assets at a high risk. You can lose your assets in no time in case of any mishaps or inability to repay the debt. 

Equity Financing

Equity financing, on the other hand, means issuing stocks to finance a business. It means someone buying company shares by putting money into your business. Unlike debt financing, the lender doesn’t look for interest on the loan money but a particular share in the industry. In this type of financing, business owners are not bound to pay anything to the lender if sales have not yet been made. Some significant sources of equity financing are stated below. 

– Angel investors

–  Crowdfunding

– Venture capital firms

– Corporate investors

– Listing on an exchange with an initial public offering (IPO)

 

Pros of Equity Financing

Following are some prominent pros/advantages of debt financing. 

1) Less Burden

One of the most significant advantages of equity financing is no obligation to repay the loan. The company is not required to pay the lender every month to invest the generated money into the growth of the business. 

2) Credit issues Gone

Equity financing is suitable for business owners who need more time to keep up with their payments. Equity financing eliminates the restrictions of creditworthiness, so business owners with a poor credit history or no financial track record can still go for equity financing. 

3) Learn and Gain from Partners

The stock sharing in equity financing may enable some knowledgeable investors to participate in the company’s operations. This can lead to various innovative and profit-driven ideas to grow the business exceptionally. 

Cons of Equity Financing

Let us have a look at the cons of debt financing.

1) Share Profit

Profit sharing is a setback in equity financing. You must share a certain percentage of the profit with the investor, which means the greater your efforts into the growth of your business, the larger the amount you will pay your investors.

2) Loss of Control

As mentioned, you are selling part of your business in equity financing. It means you no longer have absolute control over the operations of your business. 

3) Potential Conflict

Due to shared ownership, there could be potential conflicts in case of differences regarding vision, management, or development plans. 

Factors to Consider Before Making a Financing Decision

Below are some significant and worthy factors a business owner should consider before making a financing decision. 

1) Flotation costs

Flotation costs are the cost investment banks offer to float or issue stocks. Debt financing will be cheaper if the investment bank costs more to issue stocks. On the other hand, if the flotation costs are less, it is best to opt for equity financing. 

2) Interest rates

Similarly, the company must pay outstanding bonds to the lender or investor if the interest rates are high. This surely will cost more to the company. Therefore, it is best to go for equity if the interest rates are higher and vice versa. 

3) Tax rates

Tax rates also matter regarding financing. If tax rates are higher, the bondholder or the investors will pay more taxes and thus demand more compensation. Therefore, when the tax rates are high, opting for equity and vice versa is better. 

4) Earnings volatility

The best option for seasonal businesses or businesses with volatile earnings is to go for equity because they would be sure to pay for the coupons within the due time. On the other hand, companies with stable or predictable income can opt for debt financing. 

5) Business growth

For newborn businesses still experimenting and investing in research and development to grow the business, equity is a better option because paying monthly coupons with all other R&D investments would not be wiser. It is better for mature companies. 

 

The Bottom Line

To sum up the discussion, it is fair to say that debt financing and equity financing have pros and cons and do’s and don’ts. Therefore, it’s crucial to take sides with any of them. Making a financing decision in such regard is highly proportional to the nature of business. Hence, business owners must do their homework regarding their financing plan to make an informed and educated decision.