Debt Finance vs. Equity Finance

Ross Bienstock, Express Trade Capital

When business owners need cash flow, they have access to a variety of financing resources, most of which fit into one of two categories: debt and equity. Although both are equally useful in different contexts, there are advantages and disadvantages to choosing one funding method over the other.

What is “debt finance”?

Debt finance is simply borrowed money that will be paid back, plus interest. Common examples of debt financing include credit card charges and car and home purchases. There are several advantages to debt financing when compared with equity financing, first of which is that once the borrower pays the lender back, their relationship is over. Debt finance is also advantageous because it is easy for the borrower to predict their expenses since loan payments are consistent in amount and frequency. Since the lender does not have any equity in the business (meaning they don’t own any portion of the business), it does not decrease the owner’s interest in the company. Another advantage is that the company can off write interest paid on debt finance on their tax return, decreasing the effective cost to the company.

There are also drawbacks to using debt financing for your business. Using debt financing indicates that the entity borrowing the funds is extremely confident in their ability to pay them back. While it is obviously advantageous to be confident in one’s ability to repay debts, this arrangement leaves one with little recourse if unexpected difficulties affect their cash flow. The borrowing business may fall on hard times and end up with insufficient cash flow to pay its debts.

It is also important to be aware that the greater a business’s debt-equity ratio is, the riskier the company is going to be. Meaning if the amount of funds a business has borrowed approaches or surpasses the value of that business’s assets, it becomes harder for that business to seek out funding. This is a red flag to lenders and often means they won’t get involved with the business in question. As a result, debt finance can hinder the business’s progress and stunt growth.

What is “equity finance”?

If you have ever watched Shark Tank on TV, you have some idea of what equity is. The premise of the show is angel investors deciding whether or not to purchase equity in someone else’s business idea. Equity refers to ownership of shares of a company. Equity financing is different from debt financing because the funds come from investors, rather than lenders. As mentioned, once the borrowing business pays the lender back in a debt financing transaction, their relationship is over. With equity financing, however, the investor remains involved as part-owner of the business.

The biggest advantage to using equity financing is probably that if the business fails, the primary business owner doesn’t need to repay the investor. That may sound insignificant, but the fear of lingering debts after the business dissolves is all too prevalent for many small business owners. This method also leaves more cash flow available since it doesn’t create expenses.

The major disadvantage is also the most obvious. To acquire the equity funding, the business owner must relinquish a percentage of the business to the investor. Any time the business makes a profit or the owner needs to make a crucial business decision, they will have to consult the other partner(s).

Which is best for you?

Does debt financing or equity financing better suit your situation?  It all depends on where your business currently stands and who you know. If you and your business are quite new to the market, you may want to borrow traditionally to avoid giving up equity. If you have a close friend or trusted family member who might be willing to invest, you may be more interested in sharing equity with them to avoid accruing debt. No matter how you choose to finance your business, make sure you know the benefits and drawbacks of each option and carefully plan to avoid unforeseen difficulty.

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