Debt vs Equity Finance

When you are determining the best way to finance a new business or expand your existing business, there are two primary options to consider, Debt and/or Equity finance.

It’s important to understand the difference between the two choices and the pros and cons of each.

Let’s start with an explanation of the two options:

Debt Financing is the option you are most likely familiar with. With debt financing, the borrower asks a banker to lend them a specific amount of money for a specific period of time and at an agreed upon interest rate. There are many variations available for each part of a loan, but most debt financing options will include these three elements.

Equity Financing occurs when the business owner chooses to take on a partner. That partner will usually invest a specific amount of money (or time or expertise) in a business in exchange for a percentage of ownership in the business. Equity financing represents an investment in the business rather than a loan to the business.

Pros and Cons of Debt and Equity Financing

Debt Financing: Pros and Cons

The pros of debt financing are easy to understand. Once the loan is paid, the business has no additional obligations to the lender. Additionally, if the loan is paid back according to its terms, the business’s credit rating will improve and future loans and credit will usually be easier to obtain.

The cons of debt financing are just as easy to understand. Immediately upon obtaining the loan, the business needs to begin paying It back. As payments of any kind are often difficult for a new company, loan payments can significantly impact a new business’s cash flows and ability to operate. And as noted as a positive if successfully done, failing to pay back a loan according to its terms can make obtaining a new loan or credit line more difficult and costly.

Equity Financing: Pros and Cons

The pros of equity finance are easy to understand as well. Unlike a loan, an investment in your business by a new partner does not require repayment. An equity investment can allow a business to expand without taking on new debt and shore up the balance sheet of a new or growing enterprise, often making it easier to obtain other types of traditional financing (e.g. loans and credit lines). Additionally, partners can provide industry or general business experience.

The cons of equity finance should be carefully weighed before choosing this option. Equity financing requires you to sell part of your business to a partner. It could mean giving up control of your business entirely or at minimum requiring you to explain your business decisions to your new associate, who expects to make a return on their investment.