Debt Financing vs. Equity Financing

Financing your new business can be categorized into two different types: debt financing and equity financing. These terms may be new, but the concepts behind them probably are not. Check out their meanings and you'll see which may be best for you and your business.

Debt Financing

In basic terms, this is a loan. Money that you borrow from another source with the understanding that you will pay it back in a fixed amount of time. As the name suggests, this type of financing means that you have "debt" -- money that you owe to someone. The person who lends you money does not have any liberties or ownership over your business. Your relationship continues as long as you owe the money and once it is paid back, your relationship with the lender ends. Debt financing can be short-term (one year or less for repayment) or long-term (repayment over more than one year). This type of financing occurs with banks and the SBA (Small Business Administration).

Advantages to Debt Financing

  • You retain maximum control over your business
  • The interest on debt financing is tax deductible

Disadvantages to Debt Financing

  • Too much debt can cause problems if you begin to rely on it and do not have the revenue to pay it back.
  • Too much debt will make you unattractive to investors who will view you as "high risk."

Equity Financing

This type of financing is an exchange of money (from a lender) for a piece of ownership in the business. This appears to be "easy money" because it involves no debt. This type of financing normally occurs with venture capitalists and angel investors.

Advantages to Equity Financing

  • You don't have to worry about repayment in the traditional way. As long as your business makes a profit, the lenders will be repaid.
  • With the help of investors, your business becomes more credible and may win new attention from the lenders' networks.

Disadvantages to Equity Financing

  • As the business owner, you lose your complete control and autonomy. Now, investors have a say in the decisions that are made.
  • Too much may indicate to potential funders that you are willing to take the necessary personal risks, which could signify a lack of belief in your own business venture.

When a banker, venture capitalist, or angel investor is considering giving you money, they will look at your debt to equity ratio. This is the amount of debt you have compared to the amount of equity you have. To lenders, this ratio is important because it tells the amount of money available for repayment in the case of default. It also shows if your business is being run in a sensible way, without too much dependence on any one source.

When considering what type of financing you want or need, take some time to think about your business motives. How much control do you want? What are your long-term goals? With equity financing, you and your investors may come to disagree on important business decisions. When this happens, it is often best for you to "cash in" and let your investors take the business into the future without you. To some entrepreneurs who believe in their business idea and want to see it through, selling is not an option. If this describes you, equity financing is not for you. Instead, you should explore debt financing and retain control over the direction of your business venture.

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