The difference between debt financing and equity financing

While there are a range of different funding options available to businesses wanting to fuel their growth plans, one of the first decisions business leaders must make is whether they want to go down the debt or equity route.

But what is the difference between debt and equity funding? Why does this decision have such an impact on the fundraising process? And which of these options is best for your business?

We break down the difference between debt and equity financing, as well as some of the pros and cons of either option. Read on to find out more…

What is debt financing?

Debt financing is the process of borrowing money from a lender that must be paid back, with interest, at a later date.

In our personal lives, a mortgage or a car loan are both examples of raising finance via debt. Common examples of debt funding in a business environment include term loans, cash advance loans, invoice finance and asset finance.

What is equity financing?

Equity financing is a way of raising capital by selling shares of your business – this might be to experienced investors, a venture capital firm, or even to the public.

With equity, your business is not liable to make regular repayments as it is with debt funding, but it does mean diluting the ownership of your business. This may affect the power you hold in the process of decision making and business control, as well as affecting the percentage of the profits that you, as the business owner, are entitled to.

What is the difference between debt and equity?

The biggest difference between debt financing and equity financing is the value exchange between the business raising the money and the lender providing the funds.

Debt finance requires no equity dilution, but the business must “pay” for this benefit via interest on top of the initial sum.

Equity finance doesn’t require the payment of any interest, but it does mean sacrificing a stake in the business and ultimately a share of future profits.

Debt versus equity: which is better?

This largely depends on what is of most value or is most realistic to the business at the time of fundraising.

If a management team values having complete control over the business and it is realistic for the business to manage a monthly repayment schedule, then debt could be the better option.

If it is not realistic for a business to repay a loan each month and the management team would value input from a professional investor, then selling a stake in the business to raise capital via equity could be very attractive.

Both options have advantages and disadvantages that vary between each individual business case:

Pros of equity finance

The nature of equity finance means that there are no loan repayment obligations like there are when you raise capital via debt. While the investor will no doubt want to see an upside from their investment (usually in the form of business growth and their stake in the business therefore growing in value), there is not the pressure to meet a firm repayment schedule like there is with debt. This can make equity finance a great option for earlier stage businesses and those that are pre-profit, where there isn’t spare cash to repay a loan each month.

For these younger and less established businesses, the input of a professional investor or investment firm can also be a benefit, particularly where the business is run by a first-time owner or founder. The investor can provide guidance and input, using their stake in the business to positively influence its growth.

Cons of equity finance

The downside of raising capital via equity and giving up a stake, is that someone external to your business then has some control over it.

Where businesses are slightly more established, leaders may not want to relinquish control to external parties. Similarly, if a business has already been through one equity round, the management team is more likely to be interested in a cash injection that doesn’t require further equity dilution.

Equity finance can also be an expensive way of raising capital.

While it makes sense for early-stage firms and start-ups that have few alternative options, equity investors make their money back via a business’s growth. That means if your business is more established and scaling rapidly, the value of an investor’s stake could increase exponentially in a short period of time and the interest you would pay on debt during this same period could work out to cost you significantly less.

Pros of debt finance

As above, depending on the business’ stage of growth, debt can work out to be a cheaper option than equity, as the business retains complete ownership of their future success – and future profits.

A more established firm is also more likely to have visibility over future revenue and be better able to consider the serviceability of debt. Where this future revenue is really clear – in recurring revenue business models for example – lenders can also offer more attractive loan pricing due to the reduced risk exposure, making the cost of debt even more affordable.

Perhaps the biggest benefit however, is the fact that raising capital via debt requires no equity dilution. This means business leaders retain complete control and, depending on the terms of the loan, are under no obligation to involve the lender in the day-to-day business operations.

Cons of debt finance

The most obvious drawback is that capital raised via debt must be repaid.

This means the business must be confident in its growth assumptions and have a clear plan for how it will use debt finance, so that the loan is serviceable and the business does not struggle to meet the repayment schedule.

Some debt providers will also attach covenants to their loans – things such as having minimum cash reserves, or meeting performance metrics – as an additional layer of risk protection.

What is the best fundraising option for my business?

To decide on the next steps for your business when it comes to fundraising, there are a few things you need to consider:

• What stage of growth is your business at?
  This will have a significant impact on what types of funding are available to you and how affordable each of these options will be.
• How much is your business looking to borrow?
  Lenders that specialise at working with scale-ups and fast-growing firms will likely offer higher quantums, at an earlier stage of growth than what will be available from traditional lenders, so how much you are looking to raise could influence which route you take. You can read more about how much your business should borrow here.
• How will you use the money you raise?
  Some forms of capital have been designed with specific use cases in mind, so having a clear idea of how you will use the funds should narrow down your options. Most investors will want you to demonstrate a clear vision for your growth and how their capital will help you get there anyway, so working this out early on should save you time later in the process. You can read more about use cases for growth loans here.
• What type of lender do you want to work with?
  Just like businesses, the characteristics and cultures of different lenders vary drastically. A good lender/borrower relationship should feel like a partnership, so you want to ensure you work with a lender that thoroughly understands what you do and truly buys into your vision.

If you’re still unsure about the best next steps for your business, book a chat with one of our lending experts – they will be able to provide you with more information about the funding that Growth Lending can offer, as well as whether we are a good fit for your business (and your business needs!)