As a business grows, every business owner faces the debt vs. equity financing decision for funds to support growth. An owner has two choices: take on debt or raise more equity.
Debt means applying for a loan from a lender. It can be short-term, long-term, or revolving. Debt always involves some form of repayment with interest that must be made whether the company is making a profit or not.
Equity financing involves the owner giving up a share of the business. Unlike debt, equity financing doesn’t require repayment. Investors hope to see a return on their money by receiving dividends or an increase in the share price of their investment.
Understanding debt vs. equity financing’s pros and cons can help you decide which way to go.
Pros and Cons of Debt Financing
- Doesn’t dilute the owner’s portion of ownership
- Lender doesn’t have a claim on future profits
- Debt obligations are predictable and can be planned
- Interest is tax deductible
- Debt financing offers flexible alternatives for collateral and repayment options
- Debt must be repaid
- Can be difficult to qualify for, depending on financial status and credit score
- Some debt instruments restrict businesses from pursuing alternative financing options
- Higher debt-equity ratios increase the financial risk of the company
- Owners may be required to personally guarantee the debt
- Assets could be seized in case of default
Pros and Cons of Equity Financing
- No obligation to pay dividends on equity
- Possible industry experience and connections from right investors
- Investors’ money doesn’t have to be returned if business fails
- Improves financial health of business by reducing leverage
- Having to give up a portion of ownership
- Equity costs more than debt because investors risk more
- Attracting investors can be harder than getting a loan
Raising money for your business and finding the right type of financing can be time consuming and stressful. To keep cash on hand while pursuing options, owners may also want to consider a small business loan in the interim.