Debt vs. Equity Financing: Which Is Best for Your Business?
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Small-business owners generally have two basic funding options: debt financing and equity financing.
Debt financing is when you borrow money, often via a small-business loan, which you repay with interest. Equity financing is when you take money from an investor in exchange for partial ownership of your company.
Both options provide cash for your business, but each has pros and cons. Debt financing allows you to maintain full control of your business but can be expensive, especially if you have bad credit or haven’t been in operation long. Equity financing is an option for startups and pre-revenue businesses but requires giving up a stake in your company to investors who may want to influence business decisions.
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Debt vs. equity financing overview
Debt financing | Equity financing |
|---|---|
Set monthly or weekly payments. | No repayment schedule. Investors earn a share of the business's profits. |
Qualification typically based on business financials and personal credit score. | Qualification typically based on business potential and owners' character. |
Interest required. | No interest required. |
Maintain full ownership of your business. | Trade percentage of ownership for funds. |
Available from banks, credit unions, online lenders and some nonprofit lenders. | Available from angel investors, crowdfunding platforms and venture capital firms. |
When to choose debt financing vs. equity financing
The best financing for your business will be the one that supports your company’s goals and financial needs, now and in the future.
Consider debt financing:
If you can qualify
Getting a business loan isn’t always easy, especially for startups in need of financing. Lenders often require a certain length of time in business, solid credit, strong financials and some type of collateral. If you meet those criteria, you may get a competitive interest rate.
If you expect a positive return
A loan can be a good financial move for your business if you are intentional about its purpose and your projected returns are greater than the total interest you’ll pay. Another positive: Repaying debt can build your business credit, which can lead to better rates and returns in the future.
If you’re comfortable with the risk
If you put up collateral, failing to repay the debt could cost you that asset. Even if the debt is unsecured, your credit score will be at risk, and items like your home or car could be too if the lender requires a personal guarantee.
If you want to maximize your money
Debt financing may have more long-term financial benefits than equity financing. With equity financing, investors will be entitled to profits, and if you sell the company, they’ll get some of the proceeds too. This reduces the amount of money you could earn by owning the company outright.
Consider equity financing:
If you want to avoid debt
Equity financing may be less risky than debt financing because you don’t have a loan to repay or collateral at stake. Debt also requires regular repayments, which can hurt your company’s cash flow and its ability to grow.
If you’re a startup or not yet profitable
Equity financing may be necessary if you can’t qualify for a startup business loan and want to avoid more expensive options like credit cards. Just make sure the investment is a fair valuation since your business is young.
If you can find a partner or mentor
Investors can offer working capital to build your company. But their industry knowledge or experience could prove just as valuable, especially if they take an active role in your business’s growth and success.
If you’re OK giving up some control
An investor who owns a large-enough stake is entitled to voting rights and could insist on actions like electing new directors. If you eventually give up more than 50% of ownership, you can lose complete control of your company. To regain it, you’d likely have to buy out investors — which may get expensive.
Debt financing options for small businesses
If you want to finance your company with debt, here are some common types of small-business loans:
Term loans can have high borrowing limits and may be a good choice if you’re looking to expand and have good credit and strong earnings.
Business lines of credit offer a flexible way to meet short-term financing needs — for example, if you need to purchase inventory or fix broken equipment.
Invoice factoring can turn unpaid invoices into fast cash and may be an option for startups with bad credit because the invoices themselves act as collateral.
Personal loans for business are another option for new businesses that want to hang on to equity, but rates depend on your credit score and can be expensive.
Business credit cards can help cover ongoing expenses and may be necessary if you’re a startup that can’t qualify for a loan.
Equity financing options for small businesses
Here are some small-business financing options that can rely on equity:
Venture capital may come from a single person or a firm that invests from a pool of money. VCs are more likely to offer financing to established businesses than startups and will often require a seat on the board of directors, plus equity.
Angel investors are individuals who use their own money to offer businesses financing. They typically invest in startups with high earning potential, which means they may be more likely to take a risk if the return looks promising.
Equity crowdfunding is a process of raising capital from a “crowd,” or group of investors. This can be a good option for smaller businesses or those who are wary about pitching directly to an angel investor or venture capitalist. Investors can view and select business profiles to support directly via the online crowdfunding platform.
Family and friends. Getting in front of a VC or angel investor can be difficult; earning an investment is even harder. You may have better luck getting equity financing from family and friends. But if you lose their money, your relationship could be at risk.
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