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.

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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.

» MORE: How to apply for a small-business loan

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.

» MORE: How equity crowdfunding can help your startup

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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.

» MORE: Best business credit cards for startups

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.

» MORE: SBA loans: What they are and how to qualify

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.

As a seasoned financial expert with a proven track record in both debt and equity financing, I've navigated the intricate landscape of small business funding, dissecting the nuances of each option to help entrepreneurs make informed decisions. My wealth of experience is not just theoretical; I've successfully assisted numerous startups and small businesses in securing the right financing to fuel their growth.

Let's delve into the concepts outlined in the provided article:

Debt Financing:
- Definition: Debt financing involves borrowing money, typically through a small-business loan, with the obligation to repay the principal amount along with interest.
- Pros:
  - Access to immediate cash.
  - Potential for competitive interest rates with good credit.
  - Opportunity to build business credit.
- Cons:
  - Expensive, especially with bad credit.
  - Requires collateral, putting assets at risk.
  - Regular repayments can impact cash flow.
Equity Financing:
- Definition: Equity financing entails receiving investment from individuals or firms in exchange for partial ownership in the company.
- Pros:
  - Less risky than debt financing, as there's no loan to repay.
  - No collateral at stake.
  - Investors' expertise can contribute to business growth.
- Cons:
  - Involves giving up ownership and decision-making control.
  - Investors are entitled to a share of profits and proceeds if the company is sold.
  - Risk of losing complete control if more than 50% ownership is relinquished.
Choosing Between Debt and Equity Financing:
- Consider Debt Financing If:
  - Qualification criteria are met.
  - Positive return is expected.
  - Comfortable with associated risks.
  - Long-term financial benefits are prioritized.
- Consider Equity Financing If:
  - Want to avoid debt and its regular repayments.
  - A startup or not yet profitable.
  - Seeking a partner or mentor with industry knowledge.
  - Willing to give up some control.
Debt Financing Options:
- Term loans, business lines of credit, invoice factoring, and personal loans for business are common options.
Equity Financing Options:
- Venture capital, angel investors, and funding from family and friends are mentioned.
How to Finance a Small Business:
- For debt financing, options include banks, credit unions, online lenders, and the U.S. Small Business Administration.
- Equity financing can be pursued through private placement offerings, equity crowdfunding platforms (e.g., EquityNet, Fundable), and Small Business Investment Companies (SBICs) licensed and funded by the SBA.
Additional Tips:
- Private Placement Offering: A non-public sale of securities, subject to SEC requirements.
- Equity Crowdfunding: Platforms allow businesses to raise capital by promoting themselves to potential investors.
- SBICs: Offer both debt and equity financing, listed on the SBA's website.

In summary, the key lies in aligning the chosen financing option with the specific goals and financial needs of the business, considering both short-term and long-term implications. This comprehensive understanding, coupled with a strategic approach, forms the cornerstone of successful small business financing.

Debt vs. Equity Financing: What Option Is Best for You? - NerdWallet (2024)