Debt Financing vs. Equity Financing for Small Business

When a small business needs outside money for growth or other purposes, two options typically emerge: debt and equity financing.

They’re two very different ways to pump cash into a company. Debt financing involves borrowing money, while equity financing involves selling a share of a small business to an investor.

What’s the Difference Between Debt Financing and Equity Financing?

There are several differences between debt and equity financing for a small business. Types of debt financing include loans, lines of credit, and credit cards, while types of equity financing include investments from friends, family members, and venture capital firms.

Debt Financing vs. Equity Financing at a Glance

Access to Financing for a Startup

Because of a startup’s relatively short track record, it might be easier to obtain equity financing rather than debt financing. Equity investors typically are willing to take on more risk than lenders are.

Access to Financing for a Mature Company

A mature company might find it easier to secure debt rather than equity. In part, because a mature company has an easily documented track record. Plus, an equity investor might not see a mature company as an attractive target if growth of the company or its industry has flattened.

Speed of Getting Money

A small business may be able to nail down debt financing within a few days or a few weeks. Securing equity financing might take longer as the investor and the owner work out the details, such as how much of an ownership stake the investor will receive.

Funding Size

Equity financing typically lets a small business tap into a deeper pool of money than debt financing. While debt financing might top out at $100,000, equity financing can be in the millions of dollars.

Repayment

Debt financing—in the form of a loan, for instance—must be repaid with interest over a certain period of time. That’s because you’re borrowing the money. On the other hand, equity financing does not need to be paid back.

Profits

An equity investor might insist on a portion of future profits, while a debt deal typically does not include profit sharing.

Ownership

In an equity financing arrangement, the owner or owners of a small business give up a share of ownership in the company in exchange for the investment. Debt financing does not require a small business to hand over a piece of the ownership pie.

Seat on Board

An equity investor often will insist on being given a seat on the business’s board of directors, offering the investor more say in the company’s operations. Meanwhile, a debt financing deal does not include the promise of a board seat.

Which Is Right for You?

Debt financing and equity financing are two key paths for a small business to obtain outside funding, but which one is right for your business?

Debt financing may right for your small business if:

• You need cash fairly quickly: It can take longer to obtain equity financing than it is to obtain debt financing.
• You want flexibility: Unlike equity financing, debt financing opens up both short-term and long-term funding options.
• You don’t want to give up a share of ownership in your company: A lender won’t demand an ownership stake in your small business, whereas an equity investor typically will.
• You want to keep all of your profits: An equity investor may ask for a chunk of future profits, while that won’t be the case in a debt financing scenario.
• You don’t want to relinquish decision-making control: Unlike a debt deal, an equity deal might mean you need to make room for an investor’s representative on your board of directors.
• Your company has a relatively long track record: Mature businesses usually find it easier to land debt financing than startups do.

Equity financing may be right for your small business if:

• You don’t mind surrendering a piece of the ownership in your company: In an equity deal, an investor gives money to a business in exchange for a stake in the company.
• You’re OK with sacrificing some control over your business: An equity investor tends to be heavily involved in the day-to-day operations of a company in its investment portfolio.
• You don’t have much cash flow yet: A startup frequently struggles to generate revenue, while a mature business often doesn’t. Because of this, equity financing typically is easier for a startup to snag than debt financing.
• You need more cash: The size of an equity investment often exceeds the size of a debt financing deal.
• You don’t need cash right away: Equity deals normally take longer to wrap up than debt deals do.
• You don’t mind losing some of your future profits: An equity investor might want a cut of your future profits, whereas a debt financing setup doesn’t require profit sharing.

The Bottom Line

Debt financing and equity financing are not one-size-fits-all methods for a small business to secure funding. For a small business, debt financing might be the best alternative if, for instance, it wants faster access to money. On the other hand, equity financing might be ideal if your business needs a bigger injection of cash, as equity deals often are bigger than debt deals are.

To decide which financing route is best for your small business, consult with your attorney, accountant, advisers, and other professionals whose input you trust.

Frequently Asked Questions (FAQs)