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Starting a small business is incredibly exciting, but it can also be a substantial financial undertaking. Choosing which type of funding to use when launching a business can significantly impact the overall health of your business.
Here at the BBB, we understand that starting a business can be an incredibly stressful experience. That’s why we’re dedicated to providing small businesses with the resources and support they need to succeed.
One of the most critical decisions a small business owner can make is choosing between using debt or equity to finance their business. Both have advantages and disadvantages, and it’s essential to understand the differences before making a decision.
Debt vs. equity financing: What’s the difference?
Debt and equity financing are the two broadest ways to fund your business. But how do they differ? New business owners can be overwhelmed by the endless options for financing their venture. Before committing, be sure you understand the difference between debt vs. equity financing.
Defining debt financing
Debt financing is money that is borrowed in the form of a loan. There are many different types of debt financing, including bank loans and lines of credit, small business loans, peer-to-peer lending and more. The amount of money you can borrow and the interest rates you’re charged will vary based on the type of loan you’re taking out.
The most common type of debt financing for small businesses is a business loan. These loans typically come with a set term, such as six months or one year, and have fixed interest rates.
There are generally two types of business loans: term loans and revolving loans.
- Term loans are typically used to fund daily operations and often require a substantial down payment.
- Revolving loans are typically used to fund larger investments, such as purchasing a new piece of equipment.
The interest rates and fees associated with small business loans are often lower than those charged on personal loans. This is because the Small Business Administration (SBA) has specific lending guidelines that lenders must follow. SBA loans tend to be more affordable and provide more options for business owners than traditional bank loans.
Defining equity financing
Equity refers to any investment of money in a business that provides ownership in the business. This can include shares of stock, debt and other forms of investment.
Equity financing is often confused with debt financing, but several significant differences exist. The most crucial distinction between debt and equity financing is that equity is an investment in the business, while debt is a loan.
When growing a small business, it's not uncommon to sell an ownership share of the company to raise capital. Equity investors are thought of as partners in the business, and their investment provides them with a share of the profits.
While this may seem like a loan, the funds that are being raised through equity are always used to grow the business, rather than repaid to the investor at the end of a given term. That means there are no repayment terms as the investor who has purchased the share is making an active investment in the business’s long-term success and will reap the rewards as the business continues to scale.
Choosing between debt financing and equity financing
Let’s face it, choosing the right financing can be a confusing process. Many entrepreneurs get stuck between debt financing and equity financing, and there are plenty of myths floating around that can lead you astray.
One of the best ways to help you decide between debt vs. equity financing is to understand the pros and cons of each, which we've outlined below:
Debt financing
If you're considering debt financing, the first thing you should ask yourself is why you’re considering it. Debt is often viewed negatively because it comes with several associated risks. However, the right level of debt can be a valuable tool for growing a business.
Pros
Some of the pros associated with debt financing include:
- Accessibility
- Variable interest rates
- Management control
- No profit-sharing
- Tax-deductible interest payments
Cons
While there are many pros associated with debt financing, there are also some cons worth considering, including:
- Collateral required
- Can impact your credit rating
- You must maintain a strict repayment schedule
Equity financing
Now, if you're considering equity financing as opposed to debt financing, then you'll want to make sure you fully understand the pros and cons of this option as well:
Pros
Considering an equity financing option? Then you're in good company. Here are a few pros of going down this road:
- No monthly payments
- You don't pay interest to your investors
- No liability
Cons
As with any other form of debt, there are a pair of cons worth considering when it comes to equity financing:
- You give up a portion of ownership
- Investors gain a portion of your profits
Build your brand with guidance from the BBB
Whether you're considering debt or equity financing, the best way to determine which option is right for your small business is to take an in-depth look at your business and your goals. This will help you understand which financing option will best help you reach your goals while mitigating the associated risks.
For more information on properly financing your small business, check out the BBB business news feed and the BizHQ.
BBB of Southern Piedmont and Western N.C. contributed to this article.