Debt vs. Equity as a Financing Method – Which is Better?

Starting a business often requires a lot of capital. There are various different ways in which business owners finance this. When raising it from an external source, it usually comes down to either debt or equity.

But what are the differences between these two? What are the pros and cons of each? And how to decide which fits your business’s needs best? That’s what we’ll explore in this article.

What is Debt Financing?

When a business does debt financing, this means the company takes out a loan to finance its operations – it takes on debt in exchange for cash. A great and simple way to do that in the USA is through the government’s Small Business Administration’s (SBA) loan programs. About 34% of all starting businesses in America applied for an SBA loan in 2021.

Debt financing is a good option for a starting business – it allows you to get cash on hand quickly, without giving up a percentage of your ownership. That’s the main pro of debt financing; you get to keep 100% ownership in the business. 

But it also comes with risks. You have an obligation to pay back your loan, and more. All loans come with an interest rate, meaning you owe the lender more than they gave you. The current SBA loan interest rates vary between 2.75% and 16.5%. Let’s say we take on a $100,000 SBA loan for 7 years, at an interest rate of 8.5% – that means we will have paid approximately $190,547.12 by the end of the 7 years.

What is Equity Financing?

Unlike with debt financing, you don’t have to pay back the money you receive with equity financing. Instead, you give the investors part of your business in exchange for the capital they give you. In a way, your investors become partners in the business. Aside from their capital, investors will usually help you by allowing access to their network and expertise.

With equity financing, you don’t have to pay back the capital you receive. But does that mean it is “cheaper”? Not necessarily. Let’s say, again, you bring in $100,000 in capital. This time in exchange for 5% of your business. In this scenario, how much it will “cost” depends on the long-term success.

Let’s say your business goes on to become a massive success, and reaches a valuation of $50,000,000. In this case, the 5% you gave up in exchange for the $100,000 is worth $2,500,000, which is value you would have kept if you had gone for debt financing.

How to Pick the Right Method For Your Business?

But that does not mean debt financing is necessarily the better option. Yes, in the case of a big success like the example from earlier, equity financing turned out to be more “expensive” than debt financing. 

But you could argue that this valuation would have never been reached if it weren’t for the financing method chosen. Equity financing comes with the network and expertise of your investors. This means that in many scenarios you actually get more value than the $100,000 in capital. Let’s say Sequoia Capital, a California-based VC firm, invests in your business. This doesn’t just give you the capital invested, it also opens you up to a network of hundreds of other startup founders, countless unicorn founders, growth experts, and more. You can’t put a number to the value of that.

Equity capital also comes with less risk than debt capital. There are no payback dates to meet, which means you have more flexibility. You don’t have to make $X amount before a certain date, which means you can have a little bit longer of a time horizon.

On the other hand, debt capital keeps control in your own hands. You don’t have anyone to answer to. People often say: “Once you get investors, you create yourself a job.” And there is some truth to this statement. Investors make a commitment to your business, but they expect something in return. 

Choosing between debt and equity financing depends on the specific needs and circumstances of each business. There's no single best approach. Each case requires careful evaluation.

Key Takeaways

Let’s recap:

• Debt financing involves taking out a loan to quickly access cash for business operations.

• Pro: you retain 100% ownership.

• Con: you have obligations to repay the loan.

• Equity financing involves giving investors a share of ownership in the business in exchange for capital.

• Pro: no repayment obligations.

• Con: you give up ownership in the business.

• What type of capital suits best depends on the goals, risk tolerance, and long-term vision of the business and its founders.

With this information in mind, you not only know the differences between debt financing and equity financing, but you also have a better idea of which one might suit your business and its needs best.