Debt vs. Equity Financing: Which to Choose?

Every business needs financing to fund growth. The old adage is true: it takes money to make money. There are two basic types of business financing: debt and equity. Each has its advantages and its drawbacks, and over time most businesses will need both. Finding the right mix is important because it will affect the control and profitability of your enterprise for a very long time.

A wise business strategy is to select the combination of financing methods that will provide the best funding at the lowest overall cost of capital. Cost of capital refers not only to the money required to obtain financing and repay debt, but also to shareholders’ claim on your earnings.

In addition to these measurable amounts, there are also intangible costs related to the amount of control your business sacrifices to obtain capital.

Following is an analysis of debt vs. equity financing and the advantages and disadvantages of each.

What is Debt Financing?

Debt financing is a form of business financing in which a company borrows money and enters into a contract to repay the loan over a specified period of time at an agreed-upon interest rate. There are many ways for a business to borrow funds for debt financing, including short- and long-term loans, bonds, and cash flow financing.

Below, we review each of these debt financing methods, then discuss the benefits and drawbacks of each.

1. Long-Term Loans

The most common source of debt financing is a long-term loan from a bank or other financial institution. Large loans often require some form of collateral, such as real estate, equipment, or personal assets, to protect the lender. Typically, you will receive the loaned amount in a lump sum up front and will be required to repay this loan in equal monthly sums over a period of years.

The interest rate for long-term loans is generally low, making it a relatively inexpensive method of business financing. However, bank loans can be difficult to obtain if your business is new, not performing well,or your industry is deemed risky.

2. Short-Term Loans

For emergency cash needs, businesses may obtain short-term bank loans requiring repayment within a very short time—sometimes in as little as 24 hours. These loans run a higher risk and have very high interest rates, making them unwise choices for most businesses.

Short-term loans are a desperate resort for businesses in emergency situations and should be used only with careful consideration, and only with complete certainty that they will be able to repay the loan within the given time period.

3. Lines of Credit

Like a personal credit card, a business line of credit provides access to a fixed amount of money that you can use as needed, repay, and repeat. Collateral is not generally required, and interest payments can usually be avoided through on-time payment.

Be aware that the interest rate on unpaid balances may be high, depending on the company’s credit score and history. However, establishing a line of credit can be of great value in difficult times. During the COVID-19 lockdown, for instance, many businesses found themselves suddenly in need of cash. Those who had not built credit lines were in a tougher position than those who had a credit line available for emergency funds.

4. Issuance of Bonds

Investors may loan money to a corporation through the purchase of bonds. This essentially means that the investors are loaning money to your company for a specific time period at a fixed or variable interest rate. Bond holders may sell their bonds to others. Issuance of bonds may be subject to legal guidelines.  This instrument is more commonly used by a mature business.

5. Cash Flow Financing

Some financial institutions may offer merchant cash advances that are repaid over time with a percentage of sales revenue rather than fixed monthly payments. Businesses need a stellar credit score and a good relationship with their bank to obtain such a loan.

Another method of cash flow financing, often used by retailers, is management of payables. Some suppliers offer long-term payment terms that give the company time to sell the goods before payment becomes due. This effectively amounts to an interest-free, short-term loan from the supplier. This method can be a very cost-effective source of capital to generate a profit as it bears no interest or fees. This strategy can be challenging due to market fluctuations and inventory turnover rates needed to free up cash to pay payables.

6. Convertible Debt

A commonly used method of financing to bridge one equity round of financing to the next is convertible debt. Convertible debt starts out as a traditional loan but converts to equity based on specific agreed upon terms or performance benchmarks. At the time of conversion, the lender may convert the unpaid balance and accrued interest into an equity stake in the company. Businesses use this financing instrument to give the business more cash runway to achieve key milestones that will increase the valuation of the business ahead of the next equity raise.

7. Crowdfunding

A newer method of financing for small enterprises is using an online platform such as Kickstarter or Indiegogo to solicit mini-investments from a large number of supporters.

Crowdfunding has several variations that can straddle the line between debt and equity financing. In most cases, the “debt” to the investor is repaid with a product or other reward, not with money.

In crowdfunding, the platform takes a percentage of the money raised as well as a processing fee. Some platforms use an all-or-nothing model—that is, you must reach your fundraising goal in order to get the money.

Crowdfunding success has been hit-or-miss, but is often worth a try for companies with a unique product, service, or story to offer. There is no interest to be paid, and contributors’ expectations of returns are low.

Pros and Cons of Debt Financing

The primary advantage of debt financing is that it does not cede ownership and control of your business. As long as you keep up with the loan repayment schedule, you will get no interference from the lender. Another big advantage is that your interest payments are tax deductible, which can reduce your company’s overall tax rate. If your loan has a fixed rate and equal payments, forecasting expenses becomes easy.

One of the cons of debt financing is the financial risk of betting on your future ability to repay your loan. Unexpected circumstances such as a market downturn, aggressive competition, or a disaster such as the current pandemic can impact cash flow and put your company’s financial integrity at risk. Any strategy for debt financing needs to include a strong backup plan for such eventualities.

What is Equity Financing?

Equity financing refers to the sale of ownership interest in order to raise capital. The investors gain partial control of the company and a share of its profits in exchange for their investment. There are several ways to obtain equity financing, as detailed below.

1. Partnership

Many entrepreneurs find it advantageous to take on one or more partners who can provide the necessary capital. The partners may or may not be active participants in the operation of the business, but they are part-owners and entitled to a share of the profits as well as a say in the direction of the enterprise. In some cases, the partners have equal ownership; in others the entrepreneur retains a majority stake and the partners control a smaller portion of the business. The partners also generally share in the risks, which can be substantial.

2. Venture Capital

Another way for young companies, particularly tech enterprises, to obtain financing is through venture capital. Venture capitalists, also known as VCs or angel investors, are professionals who specialize in putting money into startups in exchange for a stake in the ownership and control of the business. Venture capitalists want to move the company as quickly as possible to the point were it either goes public or is acquired by a larger company, at which point they cash in on their investment and move on.

3. Sale of Stock

The sale of stock can be one of the quickest ways to raise money. If a company is privately held, it may sell partial equity to one or more private investors. Publicly held companies offer their stock on the open market. In the sale of stock, investors expect monetary returns and collectively have a voice in the direction of the company.

4. Crowd Investing

Also known as equity crowdfunding, this method allows a company to solicit group investments through an intermediary online platform such as CircleUp or Fundable. Most of these crowd investing sites require investors and companies to meet eligibility standards and federal guidelines. Funds are usually kept in escrow until the fundraising goals are met. The platform charges annual fees to both the company and the investors. Individual investors receive shares of stock on a proportional basis and hold a collective interest in the company.

Pros and Cons of Equity Financing

The biggest advantages of equity financing are that there is no loan to repay, no interest charged, and therefore less personal risk. With no added financial burdens, the company can move forward quickly. You will have more capital available to invest in maintaining and growing the business.

One of the cons of equity financing is that it means you now have one or more partners with whom you must share your profits. These investors may have ideas about the company’s direction, which may conflict with your own ideas. This can lead to frustration on the part of entrepreneurs and employees. In the case that your philosophies don’t match up, buying out the investors may cost more than the original investment.

Equity financing is also a slower method of raising capital since it requires building relationships, developing and delivering a pitch, and doing due diligence. Equity is not the kind of financing you can quickly use to get out of a bind.

Debt vs. Equity Financing

Choosing debt vs. equity financing depends on several factors, such as the age and size of your company, industry, expectation of profit, and relationship with your financial institution. Your financing should be balanced with your exit strategy, taking into consideration how much control you are able and willing to give up in exchange for capital.

Most companies find it beneficial to use a mixture of debt and equity financing. The age, size, condition, and goals of your business are factors in determining the best balance. As your company grows and circumstances change, you will probably want to reevaluate and adjust the mix.

Here are some options to consider at various stages of your business:

• A bank or SBA loan can make it easy to forecast expenses and build your credit, though at the startup stage it may be difficult to obtain. Having a positive relationship with your banker is essential.
• A partnership can bring in the upfront cash and possibly the additional expertise you need to grow, but it can be a risk if your partner does not fully understand and agree with your objectives.
• Cash flow financing and short-term loans are risky and should be undertaken with great caution. However, they can be a last-resort option for businesses with no other viable solutions.
• A venture capitalist or angel investor may be a good option if your exit strategy is to eventually sell your company, and is a good solution for growing your business to the point of an eventual sale you are willing to give up some control.
• Crowdfunding and crowd investing can bring in quick cash in the startup phase or when you begin a new venture, but your idea and presentation must be strong and unique enough to attract a lot of public interest.
• Sale of stock can be a good way to bring in capital, especially if your business is established and profitable. However, you must be prepared to deal with the ups and downs of the market.

Conclusion

In summary, there are many ways to finance a business through debt and equity financing. Each has its advantages and its risks. Keeping a healthy balance of debt and equity financing will help your company reach its full potential.

Ultimately, your goals and strategy drive your desired debt-to-equity mix.  Whether you choose debt or equity to finance your business, the challenge of deliberately and effectively running your business according to a strategic financial plan is real and essential.

If you would like assistance in determining the best mix of debt and equity financing for your business, preparing a forecast and presentation to pitch investors and creditors, or developing and measuring against a financial plan, Preferred CFO will be happy to help.

About the Author

Tom Applegarth

Human Resources Expert

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