In general, businesses have two ways of getting funding for their operations: debt financing and equity financing. Many companies decide to use a combination of both since each one has distinct advantages and disadvantages.

Here’s what you should know about debt vs. equity financing, including how both business financing approaches work, the differences between them, and when it’s better to use one over the other.

What Is Equity Financing?

Equity financing involves selling shares of your company to generate working capital for your business. There are many different types, and you’ll likely find that some are more suitable for your business needs than others.

Here are some common examples:

• Initial Public Offering (IPO): IPOs are perhaps the most familiar type of equity financing, if not the most common. They involve a private company issuing shares to the public and joining a stock exchange like the NASDAQ or the New York Stock exchange.
• Equity crowdfunding: Crowdfunding is a way to get equity capital for your business, much like an IPO, without having to go public. Someone who buys in still becomes a shareholder with many of the same rights.
• Venture Capital (VC) firms: Not to be confused with private equity firms, VC firms pool investor money to buy shares of companies they believe have high growth potential. They tend to invest in businesses that are somewhat established and attempting to scale.

Equity financing may be the most viable way to get financing for young businesses and startups. Many new companies struggle to qualify for debt due to their lack of credit history. If your cash flow is limited early on, equity funding may be your only option.

Equity financing is also beneficial for new businesses because it often involves selling shares to experienced investors. They then have a literal vested interest in your success and can lend their knowledge and connections to the cause.

Of course, equity financing doesn’t always mean raising capital from strangers, especially for small businesses. Just as you might take a loan out from your family or friends, you can collect rounds of equity financing from personal connections too.

However, you’d likely need many more of them to contribute since they’re unlikely to have access to the same level of capital as a VC firm or angel investor.

You’d also miss out on getting professional advice on your business decisions that usually come with selling shares to an experienced investor.

What Is Debt Financing?

Unless you’re running a large corporation and selling bonds or notes, debt financing generally involves borrowing from a lender using installment debt or revolving credit accounts.

Much like equity financing, the idea behind taking on debt is that you receive the capital you need to fund your business until you can get it off the ground.

However, instead of giving up business shares in return, you enter into a contract to pay back the money you borrow, plus interest according to specific terms.

There are perhaps even more debt finance options than equity finance ones. Some of the most popular include:

• Business loan: These installment loans give your business a lump sum that they can put toward operational expenses or a large purchase. They have fixed repayment terms and monthly payments. Their interest rates vary significantly depending on the lender and your credit.
• Business credit card: Business credit cards are similar in purpose and function to personal credit cards, but they usually have higher credit limits. You can use them for regular business expenses to get some cash back as well as interest-free financing as long as you pay your balances off before the roughly month-long grace period ends. 
• Business line of credit: A business line of credit is a revolving account, like a credit card. It lets you borrow up to a credit limit, pay off the balance, then use the funds again. You can wait to use the funds until your business needs them, such as a period of low revenues. They often have higher credit limits and lower interest rates than business credit cards, but they don’t have a grace period.

Unfortunately, startups and new businesses often find it hard to qualify for debt financing. Many lenders require that you be in business for a minimum period before they’ll lend to you.

The length varies, but it’s usually two years, especially with traditional lender financing options like a credit union or bank loan. Online lenders have lower requirements, but they have higher interest rates.

What Is the Difference Between Equity Financing and Debt Financing?

Equity financing and debt financing are different methods of accomplishing the same goal. In both cases, a third party provides you with the necessary capital to fund your immediate business needs.

In return, you pay them for their investment as your business grows. The primary difference between the two funding methods is in how you repay them.

With equity financing, you give up shares of your company that entitle the investor to a portion of your profits and a say over company decisions.

It doesn’t require agreeing to make fixed monthly payments, so there’s no additional financial burden to your company, but it comes at a cost to you personally.

As a simple example, say your company has 100 shares worth $1,000 each. Your business is worth $100,000 in total. Because you need financing, you decide to sell ten shares.

The equity investment would put $10,000 in cash on your balance sheet that you could use to purchase an asset or cover business expenses.

In return, you give up 10% of your future profits. In addition, when those ten sold shares increase in value, you’d miss out on those gains.

Conversely, debt financing involves borrowing funds in exchange for a promise to pay the debt funds back plus an interest payment, which becomes the lender’s return on investment.

You get to retain ownership of your business at the cost of taking on an additional financial obligation.

For example, say you take out a $50,000 term loan at 5% interest, payable over the next five years, with a $945 monthly payment.

If the $50,000 cash influx doesn’t get your business to a point where it can support that monthly payment on top of your other expenses, you risk losing your business.

Is It Better To Finance With Debt or Equity?

Whether it’s better to finance with debt or equity depends on several factors. For example, you should consider:

• Which is more accessible given your business credit scores and time in business.
• The amount of funding you need and how much you’ve already received.
• How important retaining complete ownership of the company is to you.

Here are the pros and cons of both types of financing to help you determine which one makes more sense for you.

Pros and Cons of Equity Financing

The primary advantage of equity financing is that there’s no obligation to repay any of the funding you receive through the process, at least in the form of fixed principal and interest payments.

That means equity financing is much less burdensome on a company from a financial perspective than debt financing.

It’s easy for a company to take on too much debt and go bankrupt because it can’t keep up with its monthly payments, but it’s much less of an issue with equity funding.

The corresponding downside is that selling some of your company’s equity entitles the new partial owner to a portion of company profits as well as the ability to influence company decisions.

Perhaps counterintuitively, the other significant problem with equity financing is that it tends to be more expensive than debt financing, at least in the long run.

While you don’t have an obligation to make fixed payments with equity financing, you lose a portion of your profits indefinitely unless you buy back those shares.

In addition, payments to equity investors are not tax-deductible, while interest on business debt is.

Pros and Cons of Debt Financing

Debt funding’s primary advantage over equity financing is that it lets you retain complete ownership over your business. While sharing ownership with an experienced investor can be beneficial, many small business owners prefer to maintain their autonomy.

In addition, giving up a share of your business means giving up a portion of the profits, and paying interest on borrowed funds is usually a far cheaper option than giving up part of your earnings.

For example, imagine you need $100,000 in financing, and you have two options to get it. You can either take out a business loan for $100,000 at 5% or sell 25% of your business for the same amount.

Say you make $40,000 in profit the following year before accounting for financing costs. If you were to take the equity option, it would cost you $10,000 in lost profits.

However, if you were to take the debt option, you’d have an interest expense of just $4,590 that year. It would also be tax-deductible.

For these reasons, debt is usually the superior financing option, as long as you can get it. It’s cheaper, usually funds faster, and keeps you in charge of your business.

There’s really only one legitimate drawback to debt financing. Unfortunately, it’s a big one. You can only afford to borrow so much before you overburden your company. If you take on more than you can handle, your business won’t survive.

Conclusion

Ultimately, debt and equity financing both have their place. Which one is best for your situation depends on your preferences as a business owner, the type of business you’re running, and your current growth stage.

Your business will likely go through multiple rounds of funding at different points, and you’ll have to use your judgment to determine whether debt or equity is best for you at each one.

Many business owners aim to maintain a consistent debt-to-equity ratio as they grow to keep their debt levels from getting too high. That said, in practice, the choice between the two often comes down to availability.

For example, if you build business credit and stay in business for a few years, debt financing becomes more accessible. If your business is only six months old, equity might be the only option.

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