What Is The Difference Between Debt And Equity Financing?

It goes without saying that businesses need money to function. However, this is especially true for small businesses or those that are just starting out. For small businesses that are trying to develop and grow, there are generally two basic types of funding available – debt financing and equity financing. But which one is best for your business?

As always, the answer is “it depends”. The equity versus debt decision relies on a large number of factors such as the current economic climate, the business’ existing capital structure, and the business’ life cycle stage, to name a few. Figuring out which avenue is right for your business can be confusing, and each option has its own pros and cons.

What is debt financing?

Take for example purchasing a home, buying a car, or using a credit card. These are all forms of debt financing. You are essentially taking a loan from a person or business, and pledging to pay it back with interest. This is the same for businesses.

Business owners can apply for a business loan from a bank or receive a personal loan from friends, family, or other lenders, all of which has to be paid back eventually. There are plenty of advantages to debt financing. 

Pros and cons of financing with debt

First among these is that the lender has no control over your business. The relationship between borrower and lender ends once the loan is paid back fully with interest.

Another benefit is that the interest you pay is tax-deductible. Loan repayments also tend to not fluctuate, making it easier to predict and forecast expenses.

The downside to debt financing is the uncertainty of being able to repay said debt. Debt is a bet on your future ability to pay back the loan. There is always a possibility that your company doesn’t do well, doesn’t grow as fast as expected, or the economy turns bad. Debt is an expense, one that has to be paid regularly. Failure to do so could stunt your company’s growth, or worse.

What is equity financing?

On the other side of the coin, we have equity financing. This means giving people part ownership of your company. In return, they will give you money to start or expand your business.

The most prominent difference between equity financing and debt financing is that equity financing involves investors. For example, a business could offer some of the company shares to family, friends, and just about anyone. The most popular way to initiate equity financing is to involve venture capitalists or angel investors. Think of the popular TV shows “Shark Tank” or “The Dragon’s Den” and you will have a general idea of what equity funding is like.

Pros and cons of equity financing

The most important advantage that equity financing provides is that investors will shoulder most, if not all of the risk. Should the company fail, more often than not, it does not have to pay the money back. Equity financing will also leave the company with more available cash in some cases as there are no loan payments. Finally, investors tend to take a long-term view and understand that growing a business takes time.

While the upsides sound very enticing, the downsides of equity financing can also be as large.. To gain the funding, you will have to give the investor a percentage of your company. As such, the company will have to share part of its profits and consult with its new partners any time a decision is made that may affect the company as a whole. The only way to remove investors is to buy them out, but that will likely be more expensive than the money they initially put in.

Which method works best for you?

Traditional equity financing tends to be rather difficult for smaller companies and start-ups to obtain. Venture capitalists will often be looking for a more established brand with larger reach, and are especially fond of companies that operate on a global scale. Angel investors, those who fund on a smaller scale, are more likely to put money into startups or early-stage businesses who have the potential to grow.

If you are planning to found a startup with more local ambitions, serving a local market and does not need large-scale funding, debt financing is probably a better fit for your needs; and perhaps might be your only option. More prominent startups often combine debt and equity financing to reduce the downside of both types.

In conclusion, the benefits of using equity or debt financing to fund your start-up or business costs depend on how much money you need and the size of your business. If your current goals for growth will only require a few thousand ringgit to start off with, it might be easier and cheaper to borrow money from a friend or family member, or even take out a small bank loan. 

If you have grander ambitions for your business with plenty of growth in mind, you will likely need tens or hundreds of thousands of ringgit to get off the ground. As such, equity financing might be the better bet.

Read More: The Real Cost Of Starting A Business