Business owners have a lot of options when it comes to business financing, and there is one fundamental question they must answer before they can pursue any option: which is better for their business, debt or equity financing? These are two very different options, especially when it comes to scaling an existing business; so let’s look at them in depth:
What is Debt Financing?
Let’s start with the basics. Debt financing is the catch-all term for any form of financing that comes from an external source, and that must be repaid. Usually, this repayment is in the form of the original borrowed amount (the principal) plus interest, and the repayment term is set in the financing contract. The business owner does not relinquish any control of the business and retains 100% ownership.
Examples of Debt Financing
- Traditional business loans
- Online business loans
- Secured business loans
- Unsecured business loans
- Equipment loans
- Commercial mortgages
- Merchant cash advances
- Invoice factoring loans
- Business lines of credit
- Business credit cards
- Peer-to-peer loans
- Government loans
Pros of Debt Financing
- Retain full ownership and control of your business and all future profits
- Theoretically accessible to businesses of any size, in any industry, at any stage, for any purpose
- Can be accessed quickly and conveniently
- Interest payments on business debt are tax deductible
- Repayments are usually predictable and make budgeting simple
Cons of Debt Financing
- Loan funds must be repaid, plus interest and fees, regardless of business performance or cash flow
- Business credit is at risk if loan repayments are not made on time and in full, and credit score may be adversely impacted by the additional debt being carried by a business
- Business assets may be at risk if loan repayments are not made on a secured loan
- Borrowing amount is determined by business’s financial situation, the lender chosen, and the loan type
Best Uses of Debt Financing
Debt financing is best suited for predictable, stable expenditures, including many of those associated with business growth: equipment purchases, property costs, staffing costs, and so on. A stable cash flow is needed to ensure repayments are made, so it’s not a great solution if there is uncertainty about returns or a long timeline until profitability.
What is Equity Financing?
Equity financing is defined as any form of financing that is raised by offering shares, or a portion of ownership of a business, to one or more investors. No repayments are necessary, but business owners must be willing to give up some portion of the ownership of their business, share future business profits, and possibly also relinquish control over business decisions. However, in some cases (such as with angel investors), investors don’t just offer cash – they also offer industry expertise and guidance to help you grow your business.
Examples of Equity Financing
- Angel investors
- Venture capital
- Crowdfunding (if shares are offered in return for investment)
- Private equity
Pros of Equity Financing
- No repayments required
- Access to large sums of money
- Investment terms can be negotiated in detail
- Access to experienced individuals with a vested interest in the business’s success
- Can help boost business credibility
- Does not negatively impact business credit
- Provides avenues to financing for businesses not able to get more traditional forms of debt financing
Cons of Equity Financing
- Must relinquish full ownership and potentially control of the business
- Future profits must be shared
- Dividends paid to shareholders are not tax deductible (vs. interest payments on debt, which are)
- Can be difficult and time-consuming to find investors, and then to manage relationships with them
- Some investors are more focussed on short-term profits than long-term business viability, and may prioritise profitable exit strategies (such as a merger) over your vision for the future of the business
Best Uses of Equity Financing
Equity financing works well for large, uncertain expenditures, such as investment in innovation, research, for business start-up costs, or for any project with an uncertain pay-off date. Investors can provide the financial freedom needed to enter a new market or industry, without putting stress on cash flow, and in this sense equity financing works well for business expansion. And because repayments are not necessary, margins are better, and the increase in profits can be reinvested into the business to further accelerate growth. But you do have to be prepared to compromise on business ownership and decisions, which for many is a dealbreaker. As the saying goes: debt gets repaid, but equity is lost forever.
What Works Best for Scaling a Business?
Now you know the options and their relative merits, how can you decide which is right for you? There is no single solution that works for everyone; you must understand your business’s financial position, goals, growth stage, future needs, and long-term vision, as well as wider market conditions. But answering a few simple questions can help you streamline this process:
- How important is it for you to retain full ownership/control of your business?
- Very → debt financing
- Not very → either option could work for you
- How much financial risk are you willing to take?
- None → equity financing (as it puts no pressure on cash flow)
- Some → either option could work for you
- Does your business have the predictable cash flow needed to make debt repayments?
- Yes → debt financing
- No → equity financing
- Is rapid growth, or other longer-term goals, your priority?
- Rapid growth → either option could work for you
- Longer-term goals → debt financing
- How quickly do you need funds?
- Quickly → debt financing
- Timing not important → either option could work for you
As both forms of financing have advantages, many business owners use a mix of debt and equity financing. Find out more on our blog, or speak to a Swiftfund expert to discover how you can access convenient, affordable business financing.