Posted in Business basics | by: Michael Jones

Debt or Equity Financing? Here’s How to Make the Decision Easy

Figuring out how to pay for everything is a conundrum every company has to crack. Nailing down outside funding is essential if you want your business to grow exactly how you envision it to. In fact, choosing the right financing option can have a huge impact on whether your company will eventually reach its true potential. In this article, we’ll review two common types of funding — debt and equity — so you can feel confident picking the one that’s right for you.

When to finance

First and foremost, it’s important to determine whether your business actually needs financing. Getting a small business loan or raising equity may not be the right next step for where your company is today. However, it’s still possible to grow your business slowly and with less risk by doing something called bootstrapping, which means you provide the cash yourself.

Paying back lenders and dealing with investors are serious responsibilities that can sideline your company if done carelessly. But when done right, raising external financing is the key to growth for many businesses. Once you’ve determined if there is a legitimate need and use for additional funds, there are two options at your disposal: equity financing and debt financing.

Equity financing involves finding investors who are willing to give your business money in exchange for a percentage of future profits and a say in how things are run. Debt financing is when you receive a loan, which is paid back over a certain period of time until the principal amount plus interest has been repaid.

The ins and outs of equity financing

Did you know there’s more than one kind of equity financing out there? Here are all the different types out there:

  • Friends and family: In many cases, the first round of equity financing can come from your friends and family (which is where it gets its clever name). Normally, these investments are for smaller amounts of money for smaller ownership stakes. They help business owners build their foundation so they can then go ahead and develop a viable product.
  • Angel investors: Angel investors are individuals who provide capital, often while the company is still in its earliest stages. Typically, angel investors provide $25,000 to $100,000 to a business that can show proof that their idea has merit and that the owners are driven to succeed.
  • Venture capital: This kind of financing comes from a wider pool of investors. Venture capital often provides millions of dollars of equity financing, including not just startup money, but also funds to accelerate a company’s growth.
  • Private equity: In contrast to other forms of equity financing, private equity is available for companies that already have an operating history. In many cases, private equity investors seek to add value to the company and sell it off several years later for a significant gain.

Regardless of the type of equity financing you choose, keep in mind that investors pony up funding in return for a percentage of future profits. They may also require a say in how your business is managed. These things are good to know before you take the leap.

Advantages of equity financing

So what’s so great about equity financing? The primary advantage of this type of funding is that it allows you to secure the funds without requiring any operating history. Businesses also seek equity financing to fund a risky business model, or to open a company in certain high-risk fields, such as new technology. Since investors expect a percentage of the company’s profits instead of regular repayments that start immediately, you can take advantage of that temporary reprieve and focus on strategies that provide long-term returns.

Disadvantages of equity financing

The downside of equity financing? You have to hand over a portion of your control. While debt financing may dictate the way the loan is used, the lender will not have a say in the direction the business takes. Also, once the loan is paid off, the lender is no longer involved in the business at all. In contrast, equity financing means the business is paying out a percentage of all profits for as long as the investor is involved.

How to get equity financing

Equity financing can take some time to set up because unlike a bank loan, part of the process is getting in front of the right investors and pitching your company’s vision. If you’re considering raising equity, it’s important to understand what stage of your business’ lifecycle you’re in so you can make sure that you’re structuring your pitch accordingly. For example, a seed stage pitch should look very different than a series A pitch.

Generally, it’s great to raise equity at inflection points because they’re indicators of the potential of the company and allows investors to really envision how you’ll become profitable in the future. Once you understand the types of investors you should be seeking out and have prepared a pitch deck that showcases your vision, you should create a list of all of the VCs that focus on your industry at the right investment stage. Part of the process here is leveraging your network for introductions or doing cold outreach to investment firms that you want to meet with. It’s all in who you know — or how you can make that knowing part happen.

The ins and outs of debt financing

Now, let’s explore what debt financing, or taking out a loan, is all about. There are several types of debt financing available for small businesses, depending on their needs:

  • Business credit cards/lines of credit: This is revolving debt. Interest is charged on the outstanding balance, usually on a monthly basis.
  • Merchant cash advances: This is an advance against your company’s future credit card sales. A percentage of these sales are automatically taken out on a daily basis until the advance — plus fees — is repaid in full.
  • Invoice financing or factoring: In this scenario, you “sell” outstanding invoices, receiving an advance on a percentage of the invoice, minus a fee.
  • Term loans: The business receives a lump sum for use, which is paid back plus interest on a regular schedule (usually biweekly or monthly) over a number of years.
Advantages of debt financing

What’s so great about debt financing is that it allows you to keep all decision-making power. Once the debt is paid back, the agreement between the lender and the business is completely over.

Usually, it is much faster to apply for and receive debt financing if your business has an operating history and a positive cash flow. Even if you have a low credit score, it’s still possible to receive a small business loan. However, the loan’s interest will likely be higher as a result.  

Disadvantages of debt financing

Unlike equity financing, most lenders require that you have a minimum number of years of operating history, and a minimum amount of yearly revenue to be eligible.

By now, you should be able to spot the differences between debt and equity financing from miles away. While equity financing may be the only option if you’re a brand new company, debt financing allows established businesses to keep their ownership intact. Ultimately, it’s up to you to decide which one is the best choice. But hopefully, you’re now in the right direction so you can clinch the funding you need to reach your growth dreams.

About Michael Jones

Michael Jones is the Director of Community at Bond Street, a company dedicated to making small business loans simple, transparent, and fair.