Debt vs Equity Financing: What is Best for Your Business?

When you want your business to grow, you need to raise funds. There are multiple funding options for business owners, but two very common methods are debt financing and equity financing. While the former involves taking a business loan, and therefore, you remain in control of your business, the latter involves getting a partner on board through investment, but at the cost of having your business decisions influenced by the partner/investor.

Both, debt and equity financing, are used for raising funds, and each has its own set of pros and cons. So, what is the difference between the two? Which is the best for your business? This blog explores the different aspects of debt vs equity funding to help you make the right choice.

What is debt financing?

Debt financing is the process where your business borrows money or takes a loan or cash advance loan from a private lender, bank, or non-banking financial institution at a predetermined rate of interest. The loan amount and the interest need to be paid back as per an agreed-upon duration in instalments. The money comes to your business upfront so that you can immediately put it to use for business growth.

There are two types of debt financing – secured and unsecured. For the former type, you will need to submit collateral and the latter doesn’t need any guarantee. In debt financing, the money has to be repaid, come what may.

Benefits of debt financing

The advantages of choosing debt financing for your business are:

• Economical option compared to equity financing

The cost of debt is usually lower during the early phases or the growth stage of the business. The interest payments are mostly tax deductible, meaning the taxable income of the company and the overall tax liability is reduced. Also, debt does not translate into sharing of profits later on, making it cost-effective in the long run, especially if your business is already profitable or is growing.

• Zero equity dilution

One of the biggest benefits of debt financing is that business is completely under your control. Ownership is 100% yours and so is the decision-making authority, be it business operations, strategic decisions, or long-term goals. In contrast, in equity financing, investors have a say in key decisions, leading to dilution in control.

Downside of debt financing

Debt financing can provide quick access to capital, but it also comes with certain risks and obligations that businesses must carefully consider.

• Loan repayment is a must

The capital raised in the case of debt financing is a loan; therefore, it must be repaid along with interest. This is regardless of whether you are making profits or running into losses. You are obligated to make repayments as per pre-decided schedules, straining the cash flow. This may not be easy, especially during the early stages of the business.

• Restrictive lender clauses

The lender can attach covenants like minimum cash reserves to the loan, prohibiting certain moves, or maintaining specific financial ratios. Restrictive clauses like these can limit operational flexibility.

What is equity financing?

In this form, your business raises capital, but to do so, it has to sell ownership stakes to interested investors. The investors in this case are allotted company shares, which make them partial owners of your business. They are also entitled to a percentage share in the profits.

Who can be the investors? Anyone, from your family members, friends, the public, venture capitalists, private equity firms, and angel investors. One of the core differences in debt vs equity funding is that there is no repayment clause. Hence, no interest payment on the capital raised. However, since the investors are partial owners now, they have a say in business decisions, which means that your autonomy or complete control over your business ceases.

Benefits of equity financing

Businesses can enjoy the following benefits if equity financing:

• No pressure of loan repayment

In this form of financing, capital is raised without any requirement of monthly repayments. This is a boost to startups and companies in the initial stages when funds are required to grow, but they lack consistent cash flow to make regular payments.

• Insights from professional investors

This is a big help for startups and small businesses that are just starting. Equity investors do not just lend money but bring more to the table. Their industry experience is used for mentorship, networking opportunities, and boosting business growth.

Downside of equity financing

Some of the disadvantages of taking equity financing are:

• Equity dilution

Giving up a part of your ownership stake means giving up a part of the control to another person or entity. Investors want to participate in key business matters. With differing opinions, there could be conflicts.

• Can cost more as your business grows

Equity financing can be an expensive option for raising funds. As the business starts to grow, the equity given up earlier can become a costly deal. Future profits and ownership with investors may outbalance the initial benefits of raising funds.

Debt vs equity financing: The difference

Here’s a synopsis of how the two forms of raising capital differ.

Debt vs equity financing: Which is the best option for you

Both options have their own sets of advantages and flaws. Hence, choosing between debt and equity financing is a critical decision for any business. Debt offers control but comes with repayment obligations, while equity provides capital without immediate repayment but dilutes ownership.

Debt vs equity financing: Key factors to consider

Whether and which option suits your business depends mostly on certain factors. These include – 

• The growth stage of your business
• The capital, or the amount that you are looking to raise
• The purpose of raising capital and its intended use
• The values of the owners (control versus no control)

Debt vs equity financing: Suitable conditions

Certain scenarios suit debt financing while others are appropriate for equity funding. Here a brief – 

Consider debt financing if 

• Your individual credibility is sound, and your business financials are strong.
• You expect the returns to be attractive enough to bear the scheduled repayments.
• Your financial background allows you to take the risk because in case there are no profits, you will need to repay from your pocket
• You want to earn the maximum in the event the business gets sold.

Consider equity financing if

• You do not want to get into debt, as it is risky and requires regular repayments.
• You have just started your business, and the growth to become profitable will take some time.
• You need a mentor to guide you and help you with networking within the industry.
• You do not mind sharing control with investors for the better future of the business.

Conclusion

There is no right or wrong choice when deciding on debt vs equity funding. Both are good and viable options, highly popular with businesses that want to grow. Which is better for you? It all depends on your business goals, your approach towards risk, and the stage of growth of the business. While debt lets you retain ownership, equity brings in expertise and shared risk. 

You don’t have to decide alone, though. With TallyCapital, you can assess the financial standing of your business, based on which you can choose the best financing strategy, aligned with your long-term vision.