Debt is often created by an entrepreneur when funding large purchases that could not be afforded under normal conditions. A debt arrangement means that the borrower loaned money under the condition that the money will be returned through payments with interest.
Equity is the worth of an asset minus the total of all liabilities on that asset. Equity financing is the course of increasing capital by the sale of shares in a business. The sale of ownership parts to increase finances to business is equity financing. Equity financing has a broad spectrum to increase ownership shares. Friends and family members can be asked to invest funds and gain ownership shares accordingly. Financing from other private companies can also be considered in equity financing.
Debt vs. Equity Financing
Debt vs. Equity Financing is a very strategic decision to be made by small and medium-sized business owners/entrepreneurs. One should consider all of the pros and cons of increasing business capital through debt financing or equity financing.
Advantages of Debt financing through Equity Financing
- When taking debt, the lender has no claim to equity in the business. Ownership remains the same. Business operation and bookkeeping decisions remain with the owners/entrepreneurs/executive management.
- When net profit increases, the lender will only be given the debt money and the interest in it. If business progress and rewards are larger, the entrepreneurs will reap the rewards. The lender will have no claim or share in the business rewards/profits.
- Interests on debt can be subtracted on the business’s tax returns.
- There will be no need to seek the vote of shareholders in the business for making certain decisions.
Disadvantages of Debt financing over Equity Financing
- Debt has to be paid back with interests, regardless if the business is running successfully or not.
- High interest in debt during the recession of business can dissolve the business.
- The bigger the debt to equity ratio in the business, the riskier business is considered by the investors.
- The company is usually required to place assets of the company as security/warranty to the lender.
Debt vs. Equity Financing: Which way should your business go?
- How early are the finances needed? If there is no time to wait, then debt financing is the option left to invest in the business.
- How much finance is needed? If there is a small amount to be invested, then debt can be taken.
- If a company is running successfully and financing is required urgently, debt can be taken.
- If the business is growing and successful, equity will provide a chance to attract investors with experience and knowledge. A good business relationship is established among the entrepreneurs/investors. It can have a remarkable positive impact on business in the long run.
- Debt is good only if you want to keep the business local and keep the whole ownership with you. But, if the business is progressive, reaching to other markets other than your local community, you might need to go for equity financing.
Debt and equity financing are the two options available for small to medium-sized business owners when they need to invest more money but lack the funding at the time of financing. Entrepreneurs must consider all options when choosing debt or equity financing. If the company faces a period of decline or recession, then debt may not be a good choice.
The truth is every business will most likely need to consider financing to get them through a difficult time financially. However, it is not a forgone conclusion that obtaining anything that furthers your debt is the only option before financing with debt or equity financing, research and weigh all options and choose what is right for you without harming your credit.