Understanding Debt vs Equity Financing

So, you’re a startup looking to raise some cash to supercharge growth? Or a small business trying to plug a cash flow gap? Or even a medium-sized business in need of a cash injection? Whatever your situation, you’re probably here because you want to explore business financing options, or at least prepare for the future.

Well, you’ve come to the right place. We’re going to help you out with a couple of ideas: debt financing and equity financing. 

If you’ve done some research already, debt and equity financing probably aren’t new terms. But what do they mean?

• Debt financing is where a business takes out a loan to raise cash. 
• Equity financing is where a business sells a share of its company to raise cash.

But that’s just the beginning. To really understand the differences—and choose the right financing for your business—you need to look at the details.

While the difference between debt and equity financing might seem small on paper, the impact can be huge. It could mean saving or spending thousands over time. That’s why it’s so important to understand both options.

We’re going to break down each financing type, plus let you in on a few tips on how to select the right type for you.

What is debt financing?

You might think of debt financing as traditional financing. That’s because it’s a fairly common way to improve cash flow for businesses. 

Essentially, debt financing is raising capital by borrowing money. That cash will usually be lent by a bank, an investor, or some other kind of financial institution. 

Of course, borrowing usually means you’ll agree to pay back the principal amount plus interest over a loan term.

Let’s dig a little deeper:

• Interest: Debt financing—essentially borrowing money—comes at a cost. Lenders take on risk when they loan you money, and they expect to be paid for it. That cost usually comes as an interest rate, which can be fixed or variable. Your exact rate depends on factors like your creditworthiness, the loan term, and broader market conditions.
• Repayment schedules: Sure, some loans allow grace periods before repayment begins, but many won’t. After that, it will be a case of paying back (usually fixed) sums in allotted installments.
• Types of debt financing: There’s more than one type of debt financing. The standard type is a bank loan, but you can also use bonds, debentures, lines of credit (where businesses can withdraw and repay funds as needed), and trade credit (which is short-term credit extended by suppliers with deferred payment terms).

Borrowing money can feel daunting, but debt financing is a common way to raise capital when times are tough. With careful planning and smart management, you can avoid unnecessary strain and get the most value from your loan.

What is equity financing?

Equity financing is another popular way for businesses—especially startups that can’t yet commit to repaying a loan—to raise capital.

The key difference? It doesn’t require direct repayment. Instead, you give investors a share of ownership in your business.

So while you won’t necessarily have to pay the money back, you’ll pay by giving up a portion of ownership and control to investors.

What does this look like in practice?

Equity financing process

Picture this: a business needs to raise capital through equity financing. What process do they need to implement to get that all-important cash?

1. Valuation and preparation: The business will need to determine how much their shares are worth. They’ll base this on factors like assets, revenue, growth potential, and market conditions.

Then, they’ll need to jump through a few procedural hoops (like drafting shareholder agreements).

2. Finding investors: The next step is pretty straightforward: reach out to the people who might want a slice of the cake!

3. Issuing shares: Once an investor is on board, it’s time to seal the deal. They send the cash, the business issues them the shares. 

4. Post-financing responsibilities: With equity financing, it doesn’t end there. The investor may now have a say in how the company runs, and there’s an obligation for the business to provide financial disclosures and updates to shareholders.

Impact on ownership

Debt financing doesn’t have any impact on ownership, but equity financing does. As you’re selling a part of your company, there are potentially big implications:

• Your ownership percentage could be diluted to accommodate new shares.
• You might have to give investors some decision-making power.
• You won’t have to repay the loan, but you’ll have to share future profits.

If you’re a startup, it could be helpful to have an experienced investor on board. Equity financing is ideal for businesses seeking large capital injections without the burden of debt, even if that means less control.

Debt financing vs equity financing: What’s the difference?

Debt financing and equity financing both achieve the same goal, but they do it in different ways. These differences can have significant implications for your business down the line, so it’s important to grasp them before you start seeking financing.

Some of the major differences are as follows:

• Ownership implications: With debt financing, the lender gives you cash and you pay it back. Therefore, the lender has no control over your business, it’s simply transactional. With equity financing, the lender is making an investment, not simply a loan. In return, they’ll expect shares in the business. You’ll give up some ownership to them.
• Repayment obligation: With both financing types, the aim of the lender is to recoup, and to make a profit, on their loan. But they do this differently. With debt financing, borrowed funds must be repaid with interest according to a fixed schedule. With equity financing, there’s no such repayment. Investors still earn returns through dividends or stock value appreciation.
• Financial risk: Repaying a short-term loan is always risky. Even more so if the loan is large, and with debt financing, you’ll have to meet those payments regardless of your business’ performance. Although with an equity model, as you’re giving up some ownership, it’s generally considered lower risk as you don’t have to make any repayments.
• Cost of capital: There aren’t clear answers on which financing type costs more, as it depends on the loan size and your business’ performance. Interest payments can stack up with a standard loan (although they’re sometimes tax-deductible). On the other hand, equity financing can be more expensive in the long run due to profit sharing with investors.
• Investor influence: With debt financing, lenders don’t have any say in your business operations (that is, unless you default). With equity financing, investors may have voting rights and influence strategic decisions.

Advantages of debt financing

Still not sure which type of financing is the way forward for your business? 

Let’s start with debt financing:

• Retain full ownership: Unlike equity financing, debt financing doesn’t require you to give up any ownership of your business whatsoever—no handing over control to investors, no claims on your profits. With debt financing, the deal is confined to the loan and the loan only.
• Tax advantages: Did you know that interest payments on debt are often tax-deductible? This can help businesses to keep the cost of borrowing down as much as possible.
• Predictable repayment structure: Fixed repayments make it easier to budget and forecast. It’s also nice to have a final payment in sight, after which the debt is paid off.
• No profit sharing: Assuming you haven’t already given out shares of your company, you can keep all the future profits of your business.

Disadvantages of debt financing

Debt financing does come with a serious obligation to repay, as well as some potentially strict terms that must be fulfilled:

• Obligation to repay with interest: No matter how your business is performing, you’re required to repay your loan in full—with interest. If cash flow gets tight, this can sometimes make debt harder to manage. But with careful financial planning, you can stay on top of your repayments and avoid bigger problems.
• Financial risk and default consequences: There’s always a chance you could fail to repay a loan (or at least individual payments). If that happens, you could face penalties or even legal action. Not to mention, it could also take a hit on your business’ credit rating.
• Collateral requirements: Don’t like the sound of pledging assets as collateral for your loan? Then debt financing might not be for you. If you were to default, the lender could seize important assets.
• Potential overleveraging: If you’re looking for a one-off loan, you probably don’t need to worry about this. But if you’re relying on lots of loans to stay afloat, overleveraging can become a problem. It can create a high debt-to-equity ratio, making investors wary.

Advantages of equity financing

We’ve covered the pros and cons of debt financing. Now, it’s time to put equity financing under the microscope. 

Let’s examine the main benefits which could make equity financing a better choice for your business:

• No repayment obligations: Equity financing doesn’t come with any repayment obligations. At least, not with fixed payments. It’s the lender who’s taking on the risk by investing in your company. This leaves you free to reinvest profits into growth rather than simply repaying debt.
• Reduced financial risk: No loan repayments equals less chance of cash flow problems. Assuming you don’t have any other debts, there’s pretty much no risk of going under due to unpaid loans.
• Access to more capital: Why is equity financing so popular with startups? Well, it’s partly because companies can secure larger cash injections than they can with traditional loans. Venture capitalists might be willing to front large sums in exchange for shares.
• Professional guidance: Having an experienced investor on board could actually be a major asset. They could bring industry expertise, mentorship, and strategic connections to the table and help you navigate the market. Debt financing gives you no such support.

Disadvantages of equity financing

Equity financing still comes with compromise and risk, even if that risk isn’t in the form of loan repayments:

• Dilution of ownership: Put simply, selling shares reduces the founders’ percentage of ownership, meaning potentially lower personal profits down the line. And the more equity the business raises, the more control the owner has to give up.
• Loss of control: In return for your cash injection, you’ll have to hand over some control over business affairs. Investors may ask for anything from voting rights to a seat on the board, which can significantly impact the direction of the company.
• Sharing future profits: Just like control, you’ll also have to give up some future profits. Unlike debt financing, where repayment ends after the loan is paid off, equity investors expect a return through dividends or increased share value. The total amount the investor makes could end up being far more than that of a traditional loan.
• Longer and more complex process: Equity financing takes more time and is generally more complicated. There are legal processes, financial forms, and regulatory documents to see to. 

How to choose between debt and equity financing

Of course, you may already have an inclination based on a fundamental aspect. For instance, giving up control could be a red line, or perhaps you don’t want to risk cash flow problems with a traditional loan.

But you should take the time to consider some other factors, too. All of these factors will play a role in your decision, so take the time to:

1. Consider your growth stage: If you run an established company with solid profits and a strong financial history, securing debt financing might be easier. You may feel confident about making repayments and prefer to keep full control—without giving away ownership.

But what if you’re a younger company? Startups may not have the stable revenue or spare cash lying around to get good debt finance. Here, equity finance could be a better option. 

2. Assess your financial health: Are you in a good position with strong, predictable cash flow? In this case, debt financing might be the way forward.

Haven’t achieved that yet? For businesses facing a more irregular cash flow, equity financing could be safer.

3. Determine ownership and control preferences: Is giving up ownership a line in the sand for you? In which case, debt financing is better.

However, if you’re willing to share ownership and perhaps receive expert guidance in return, equity finance could be the perfect solution.

Conclusion: Making the right decision for your business

So what does all of this come down to? We know that both debt financing and equity financing are great ways to secure short-term capital, but in exchange for two very different payment models.

If we had to summarize, we’d say this:

• If you’re an established business needing cash to solve a temporary cash flow problem and you don’t want to give up any control over your company, then debt financing is probably for you.
• If you’re a startup wanting a larger investment to get things moving, and you’re willing to take on some experienced investors as guides, then equity financing could be the better option.

Ultimately, it depends on your unique needs and preferences.

Why not start taking control of your business’ finances right now? QuickBooks’ cutting-edge tools help businesses stay on top of their finances and secure healthy growth. Explore our software today!