Debt vs. equity financing: What you need to know

On average, small businesses spend $40,000 in their first year of business. Most people don’t have that much cash on hand to fund their business, so small business owners seek funding to help get their business off the ground.

There are a number of ways to fund a business, from crowdfunding and business loans to venture capitalist financing. Business funding sources fall into two categories: debt financing and equity financing. Debt financing is when a company borrows from a lender and must repay the money. Equity financing is when the business gets cash from an investor who then gets a share of the company.

Debt vs. equity financing

When to choose debt financing

Debt financing comes with the benefits of keeping full business ownership and allowing for business credit improvement. Additionally, there are typically more funding options for debt financing. You can find everything from traditional business term loans to business credit cards and bad credit loans.

You should choose debt financing if:

• You want to maintain full company ownership. Debt financing doesn’t require that you sell any shares of your business.
• You have an established business history with a good credit score. Many lenders require at least two years of financial history and a credit score of at least 550.
• You’ve established the regular income required to pay back your debt. Make sure your monthly budget includes enough money to pay the predicted monthly payment for your debt.
• You predict your business will make more than the cost of the loan. Taking out a loan requires paying interest and loan fees. If the added cash flow from the loan means you will make more than these costs over time, the loan is likely worth it.
• You understand the risks. When you take out a business loan, it usually requires that you have collateral or a personal guarantee. If the loan isn’t paid back in the time agreed, you could have your collateral or personal assets taken away to cover loan costs.

When to choose equity financing

Equity financing comes with the obvious benefit of not accruing debt. In exchange, you will no longer have full ownership of your company. But it’s not always the best option. However, it’s notoriously difficult to raise business capital this way.

You should choose equity financing if:

• You don’t qualify for any business loans. If lenders aren’t prepared to give you a business loan, you may need to consider equity financing as an alternative.
• You’re willing to put in the work. Equity financing involves convincing people that your business is worth investing in — and people don’t usually part with money easily. Be prepared for a lot of work and many pitches to investors before you find the right fit.
• You want to bring in a business advisor. It’s common for investors to want involvement in a company when they give money for startup costs. This can be a bonus for companies who need the business wisdom of more experienced industry leaders.
• You’re open to transferring partial ownership of the company. Most types of equity financing require that you transfer ownership shares to the investor.

Types of debt financing

There are several types of business loans and debt financing methods available. You can find options from both traditional lenders and alternative lenders. Plus, different lenders cater to different types of businesses and financing needs, such as semi-truck financing or invoice factoring.

Term loans

A business term loan is the most common type of loan. Lenders give businesses a loan disbursed in a lump sum, and the business must pay back the loan and any interest in regular increments as specified in the loan terms.

Business credit cards

Business credit cards have a revolving line of credit that you can reuse as you pay it back. They can be a great option if you have multiple low-cost needs over time and often come with perks, such as grace periods, travel rewards, cash back or an introductory APR. They can also help you build your business credit if you make timely payments.

Business lines of credit

Similar to a business credit card, business lines of credit give users a revolving line of credit. You can use it for things like equipment or inventory purchases, or to cover payroll. While interest rates are often higher than for long-term loans, the requirements to qualify aren’t as strict. A business line of credit may be right if you can’t qualify for a business loan but still want to build business credit and get extra funds to help with business cash flow.

Invoice factoring

When you have a number of unpaid invoices but need the cash now, invoice factoring could help get you the funding you need. Factoring companies purchase your invoices and give you a large portion of what you are owed. The client then pays the factoring company when they are ready to pay the invoice, and the factoring company pays your business any remaining funds you are owed after taking out an agreed-upon percentage of the invoiced amount.

Merchant cash advances

A merchant cash advance can be a good alternative financing option if you use credit and debit card sales in your business. The fees are typically much higher than a business loan, but merchant cash advances can help you solve temporary cash flow issues and are easy to qualify for. The lender for a merchant cash advance gives you a lump sum based on a prediction of future credit card sales. As you generate revenue, you repay the advance.

Personal loans for business

Sometimes, you can’t qualify for a business loan, but you can qualify for a personal loan. When you are just starting out, using a personal loan to fund your business can make the most sense. Personal loans generally have a lot of flexibility in how they can be used. They also don’t require you to have a business credit score or financial history to receive any funds.

Types of equity financing

Equity financing can be great because it doesn’t have the same typical requirements as traditional business loans. But it requires convincing an investor your business is worth their investment. There are a few different ways to find equity financing.

Angel investors

If you watch Shark Tank, you know about angel investors. These are high-net-worth individuals who invest in startups during their early stages. Angel investors typically want company shares or royalties in exchange for their investment. But they are often entrepreneurs themselves and can also provide guidance for the company in addition to funding.

Equity crowdfunding

There are multiple types of crowdfunding, but equity crowdfunding specifically involves getting small investments from many individual investors in exchange for giving them a small piece of company ownership. This can be a good funding option if you have an exciting idea that you are having trouble getting funding for. Building a compelling product mockup or promo video can help get more investors on board with your business.

Venture capital

Venture capital (VC) firms raise money from limited partners to fund exciting new startups in specific categories. In exchange for their investment, venture capitalists usually expect a percentage of the company and may sometimes request a seat on the board. They look to fund innovative or exciting new startups that don’t qualify for traditional funding methods yet.

Private investors

Private or individual investors can be a great funding option if you know someone willing to invest in your business. This can be friends, family members or anyone else you know through your network. If you know the investor, they may be willing to give you more favorable investment terms. But it’s important to make a clear agreement with anyone you know so you don’t ruin your personal relationship.

The bottom line

Finding funding for your business takes time, research and hard work, no matter which type of funding you want. Equity financing allows you to get funds you don’t have to pay back but requires you to give up partial ownership of the business. Debt financing comes with more options for loan types and lender types — such as alternative lenders and traditional lenders. But debt financing means taking on debt and the associated costs.

Consider your business needs and history to determine the best financing option for you. Research several finance options before deciding how you will get the funds your business needs.

Frequently asked questions

• Is debt or equity financing better for a small business?

• Why would small businesses prefer debt to equity financing?

• Is debt or equity financing better for startups?