What’s the Difference Between Debt and Equity Financing?

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When a business is in need of financing they can choose to fund it through the use of debt or the use of equity. One fundamental way to differentiate debt financing from equity financing is to recognize that debt financing must be repaid, whereas equity financing does not.

Finding ways to fund a business is a daunting task for entrepreneurs. Deciding on which financing is best often rises to the level of befuddling. Read on to learn the difference between debt and equity and, to discover which type of financing is better suited to meet your financing needs.

Debt Financing for Businesses

An example of debt financing is when a business owner borrows funds from an outside source with a commitment to repay the balance, plus the interest earned during the term. The entity/investor offering debt financing is typically called the lender, the bondholder or the debenture holder.

difference between debt and equity

At its most basic level, debt financing is essentially the same as a loan. It is used most often at the beginning of a business start-up, or when a business is looking to expand. Banks who offer debt financing are choosing to invest in a business without owning any part of that business.  They, therefore, do not share the business’ potential operating risks, just the risk associated with the debt financing’s complete repayment.

Debt financing largely follows the same rules as traditional bank loans. When the debt financing has been secured, the borrower is given a monthly repayment schedule to follow. In order to receive more advantageous loan rates and terms, some business owner’s provide business-related collateral – like accounts receivables, equipment or even inventory.

The interest due from debt financing practices provides a tax benefit, which is unavailable with equity financing solutions. The tax benefit generated by the interest paid reduces the business’ profit and thus, lowers the business’ tax liability.

Debt Financing – The Good and the Bad

Most small business owners will eventually find some sort of debt financing in the financial marketplace. One positive facet regarding debt financing is that it allows a small business owner to retain control of their business. The business’ debt financing is just one small slice of the business’ financials and operations.

But be forewarned, debt-financing terms lean towards the expensive end of the rate curve. Smart, experienced business owners take great care to search out the most cost effective debt financing. For those using debt financing as a primary funding source, remember that the debt financing monthly payments begin one month after the funding of the loan. This can be challenging because the new business has barely enough time to operate at full throttle.  If you plan ahead, this protracted time situation can be avoided.

Debt financing plans often require the business owner to personally guarantee the business loan. So, if the business defaults on the debt financing, the business owner becomes solely and personally responsible for that debt.

 

Equity Financing for Businesses

Equity financing is accomplished by offering individual shares for sale (of a company) to interested investors. Equity investors share in the business’ profit, as long as they remain shareholders.  While equity financing can reach into the hundreds of millions of dollars, small business owners typically ask family or friends to help fund a new business idea or an inspired expansion. However, remember that venture capitalists are always looking for a great idea and opportunity.

However, it is crucial to highlight that those investors providing equity finance become, through their investment, partners in your business. In fact, shareholders have decision-making abilities through their right to vote on business matters. An equity investment includes sharing the risk in the business’ operations and plans. Because equity investors absorb addition risk, they seek higher returns than debt investors.

Equity Financing – The Good and the Bad

Equity financing isn’t as readily available for small business start-ups, unless that business has massive amounts of luck in addition to an attractive business plan in the technology or innovation business sectors.

If applied appropriately, equity financing is a way in which a business owner spreads the business’ financial risk among a significant amount of people. As the number of owners increase, each outstanding slice of risk is reduced accordingly. However, the dividends that are paid to the equity investors are not due until the business is operating with a profit.  If the business fails, none of the equity invested needs to be repaid.

On the down side, each equity owner causes the original owner to lose some control of their business. If the collective equity shares are equal to more than 49%, the business owner can lose significant control.

It is noted that the dividend payments generated by the business’ profit is paid to equity holders as a return for their investment. However, dividends offer no tax benefit to a business because they are not a tax-deductible expense.

The Difference Between Debt and Equity

It is important to understand the difference between debt and equity because each form of financing impacts the business’ financials in different ways.

Debt and equity are both ways in which one can muster up some money for general business purposes. The difference between debt and equity can be broken down in to specific categories of financial characteristics.

Many business owners in need of cash take advantage of the loans offered by the federal government’s  Small Business Administration (SBA). Their portfolio of loan options require stricter underwriting criteria, however, the Small Business Administration’s small business loans include more advantageous terms and rates.

If you hit a brick wall when searching for financing, check out these alternate financing scenarios.  But note, these options increase borrower risks. They include a business credit card, a merchant cash advance, or even a home equity line of credit.

While there are many types of financing to choose from, be vigilant and patient in your search for business financing. Will it be debt financing? Or, will it be equity financing? It simply depends on the type of business, the business owner’s need for control, or the creditworthiness of the business owner.

Like any other adult decision one makes – Select the financing choice whose advantages outweigh the risks, at least for your particular situation.