The difference between debt and equity financing
Business owners now have a variety of financing resources they can utilise to build their business. But what one is the best option?
Sources of funding sources are usually divided into two categories; debt and equity. Debt financing involves borrowing money from an outside source and paying back the borrowed amount plus the interest at a later date.
Secured loans, commonly offered by banks, are one type of debt financing. These loans are typically paid back in monthly instalments and require a personal guaranty for the borrower.
Debt financing can be used to fund almost any kind of business. Lenders don’t have any say in how the business is run i.e. the relationship business owners enter into with lenders ends as soon as the lender is paid back.
However, the lending criteria for debt financing can be quite strict. Debt must be repaid every month, regardless of how well a business is doing. Unfortunately, that means that if the business has a decline in sales, owners may find themselves unable to make the monthly loan payment.
Equity financing involves raising capital by selling shares of a business to investors. Unlike debt financing, the capital raised through equity financing isn’t paid back in monthly instalments with interest. Instead, when the investors put their money into the business, they become partial owners of that business and are therefore entitled to a share of the business’s profits.
Equity financing does not divert capital from the business to pay down debt. It also shares the business risk with the investor.
Using equity financing to fund a business also means that owners don’t have to pay investors back immediately, allowing for more time to grow the business.
The biggest disadvantage of using equity is that equity investors will own a percentage of the business. Owners who unintentionally give up too much equity in their business can quickly lose control. This can become a serious problem for business owners who also want to secure additional debt financing.