Debt vs. Equity Financing: Which Way Should Your Business Go?

Debt vs. Equity Financing: Which Way Should Your Business Go?
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Your small business needs extra capital. Should you take out a business loan or look for an investor? Figuring out how to finance your business is an important decision that can have big consequences. So which is better? Debt or equity?

Let’s quickly go over their differences, then talk about how you can make this big decision.

What is debt financing?

Essentially, debt financing is where you borrow money from a lender that you’ll eventually pay back, plus interest. If you’ve ever taken out a loan, you’ve financed something with debt.

Related: 4 Lessons Learned in Getting Bank Financing

Pros of debt financing

  • With a business loan, you’re in control of how that extra capital gets spent. Some lenders impose certain restrictions, but for the most part, what you’re financing is up to you.

  • A business loan won’t leave a lasting impact on how your business gets run, other than the loan payments you’ll owe.

  • Debt financing is a flexible category. There are many different kinds of business loans with wide ranges in how much money you’ll get and how long you’ll make repayments.

Cons of debt financing

  • You’re paying for the cash you get. Although, if you plan correctly, anything you borrow should help you make even more back.

  • Depending on your credit score and financials, it can be tough to qualify for the loan you want.

  • If you fail to repay the loan, your business’s assets could get seized by the lender.

What is equity financing?

Equity financing is where you trade ownership of your business to angel investors or venture capitalists -- in return for their capital.

Equity is especially important for certain industries and kinds of businesses, like technology startups and companies with global aspirations. Almost $60 billion in venture capital was invested across the United States in 2015.

Related: Financing Face-Off: Debt vs. Equity

Pros of equity financing

  • You don’t have to pay interest on the capital you raise, so there’s no need to put your business’s profits into debt repayments. This means you’ve got more cash available to grow your business.

  • With the right investors, you can get great experience, wisdom, industry connections and much more. These relationships can last you a very long time.

  • If your business fails, you’re not required to pay back investments.

Cons of equity financing

  • It takes a long time -- especially when compared to some of the fastest debt financing options out there.

  • You’re giving away ownership of your business, and with that, decision-making power. You’ll have to consult with investors, and you might disagree over the direction of your company. You might even be forced to cash out and abandon your own business.

How do you know which is right for you?

If you’re having trouble deciding between debt and equity financing, here are five questions to ask yourself.

1. How soon do you need financing?

If you need cash as soon as possible, then debt financing is the way to go. You can get business loans incredibly fast -- in a matter of hours even, if you apply to the right lenders. Meanwhile, equity financing involves finding the right investors, pitching your business, drawing up the legal documents and more.

However, if you’re not in a big hurry, either option can work for you. The biggest and most affordable loan options -- like a SBA loan -- will probably take around as much time as equity financing.

2. How much capital do you need?

If you don’t need a lot, or you’re only looking for a small amount, then debt financing is the better choice. Equity financing rarely comes in small amounts, but you could get business loans for as little as $10,000 or less.

Even if you’re looking into early-stage investors, they’ll often look to spend $300,000 or more -- in return for as much as 50 percent equity.  But if you could use more cash, like hundreds of thousands or even millions, then again, either debt or equity could be right for you.

Related: A New Kind of Financing That Doesn't Involve Taking on Debt or Giving Away Equity

3. Are you looking for more than just money?

If so, equity is probably for you. Debt financing is transactional. You borrow, then you pay back what you owe. Equity will give you access to an investor’s knowledge, contacts and expertise. You get to establish a relationship that could have a hugely positive effect on your business -- as long as you’ve partnered with the right people. If all you want is more cash in your bank account, then it might be best not to get involved with investors.

4. Do you mind sharing your business?

Some entrepreneurs prefer to keep their businesses to themselves -- and that’s okay. If you don’t want to lose control over how your business operates, then equity financing isn’t the way to go. If you’d welcome the experience and expertise of an investor, or if you’re more concerned with funds than ownership, then either path could work.  

5. How big do you want to get?

Angel investors and venture capitalists often look for companies with the potential to grow into national brands or global businesses. If that’s your goal, then equity can help you get there. However, plenty of entrepreneurs prefer to run a local business, staying small because they like the individuality, autonomy and community aspect. If you fit that mold, equity probably won’t be an option.

Finding the right kind of financing is a big deal, and it can have a deep and lasting effect on how your business runs. Also, don’t discount combining debt and equity financing, according to what you need at the time. Plenty of businesses make use of both.