Debt vs. Equity Financing: What Option Is Best for You?
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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, but each has pros and cons. Debt financing can be expensive, especially if you have bad credit. While equity financing requires giving up a stake in your company and giving investors input in business decisions.
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.
You expect a positive return. For example, debt financing could be worth it if you take out $200,000 with an 8% annual percentage rate but project a return of 15%. Another positive: Repaying debt can build your business credit, which can lead to better rates and returns in the future.
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.
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.
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.
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.
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.
Business credit cards can help cover ongoing expenses and may be necessary if you’re a startup that can’t qualify for a loan.
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.
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.
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.
How to finance a small business
If you want to finance a small business with debt, you can apply for a loan from many places, including banks, credit unions, online lenders and the U.S. Small Business Administration.
To raise equity financing, one option is a private placement offering or an unregistered offering.
Such an offering wouldn’t qualify as a public sale of securities, so you wouldn’t need to register with the Securities and Exchange Commission or report financial information. However, you would need to meet certain SEC requirements. Things can get complicated, so consult a tax professional and a securities lawyer before pursuing this option.
Equity crowdfunding platforms are another way to get your business in front of investors. These sites let you promote your company to raise capital. Platforms include EquityNet and Fundable.
The SBA also licenses and funds Small Business Investment Companies, or SBICs. SBICs offer debt and equity financing, and you can find a directory of options on the SBA's website.