A Guide to Debt Financing vs. Equity Financing

Corporations regularly need infusions of money – perhaps to hire new employees, fund new projects or raise money for an acquisition. In this situation, they typically face a choice between two options for financing: debt vs. equity. Debt financing is another term for borrowing. Equity financing involves selling part ownership of a company in exchange for money. Here’s how each financing method works, and the pros and cons of each.

What Is Debt Financing?

With debt financing, a business receives money that it is obligated to pay back. Usually, the repayment occurs with a series of monthly or other regular payments. In addition to paying back the borrowed amount, the business has to pay interest to compensate the lender.

The borrower often has to put up collateral that the lender may claim ownership of if the borrower doesn’t make the payments as required. However, beyond this, the lender doesn’t get any ownership of the business. This is a crucial difference between debt and equity financing.

There are numerous types of loans. Selling bonds is another form of debt financing, and one of the most common for corporations. Both public and private corporations issue corporate bonds, which are a type of fixed-income security. Corporations place these investments on the open market to help fund projects and other major financial undertakings. Investors can purchase corporate bonds on either the primary or secondary markets, and they offer predictable payouts and strong liquidity.

Corporate bonds are structured in a wide variety of ways: fixed interest rate, variable interest rate, zero coupon, convertible, callable and junk.

Bank loans are another common way corporations obtain money through debt. Just as consumers get bank loans to buy cars, business owners get bank loans to buy equipment, build warehouses and add employees. Alt-fin and fintech lenders take applications online and use algorithms to qualify borrowers with no need to enter or use a bank to get a loan.

In addition to bank loans for specific amounts and purposes, there are lines of credit. These may be used for any purpose or left unused until needed. Accounts receivable or invoice factoring is a kind of debt financing that lets businesses borrow using bills to customers as collateral. Business credit cards are also a type of debt financing.

Debt financing is easy to obtain. A business owner fills out an application and perhaps meets with the lender to explain how the loan will be used and repaid. It takes little time and the main requirements are financial stability and sufficient cash flow to make payments.

What Is Equity Financing?

With equity financing, business owners sell part of ownership of the business in exchange for money to expand or improve it. There are no regularly scheduled loan payments or interest to pay. But business owners will surrender a level of control and decision-making authority approximately equal to the ownership share they are selling.

Selling shares to the public on the stock market is a common form of equity financing, however, it’s not the only option for businesses looking to raise capital in exchange for an ownership stake. Here are some of the most common types of equity financing options:

Venture Capital: This type of equity financing is popular among high-growth startups. Venture capitalists invest substantial amounts in a business in exchange for equity, often bringing expertise and networking opportunities along with the capital.
Angel Investing: Similar to venture capitalists, angel investors provide capital for startups or early-stage companies but typically in smaller amounts. They may also offer mentorship and advice.
Stock Offering: Public companies may issue stock to raise funds. This can dilute existing ownership but provides substantial capital without the burden of debt.
Crowdfunding: Platforms like Kickstarter allow businesses to raise small amounts of equity from a large number of people, usually in exchange for perks or early access to products rather than a share of profits.
Family and Friends: Small businesses and early-stage ventures may also rely on capital from family and friends, who receive an ownership stake in exchange for their investment.

Pros and Cons of Debt and Equity Financing

When considering either financing option – debt or equity – it’s important to weigh the advantages and disadvantages of both routes.

The pros of debt financing include no loss of control, less delay in receiving funds and many options for obtaining it. You can also get by claiming interest on debt as a deduction from profits. Debt financing is often the only choice for most companies because they lack the growth prospects equity investors want.

However, the drawbacks include the fact that it locks the company into what may be a long series of sizable payments. It can be hard to qualify for loans at attractive rates – or any loans — especially for companies most in need of capital. If the business can’t pay the loan back, it risks defaulting and even being forced into bankruptcy.

Pros of Debt Financing	Cons of Debt Financing
Control: The borrower retains full control of the company as lenders have no claim over business operations or decisions.	Repayment Obligations: Debt must be repaid regardless of business performance, which can strain cash flows, especially in downturns.
Tax Benefits: Interest payments on debt are tax-deductible, potentially lowering the business’s taxable income.	Credit Constraints: Securing debt financing requires good credit, and too much debt can adversely affect a company’s credit rating.
Fixed Costs: Loans have fixed repayment schedules, which can aid in financial planning and budgeting.	Collateral Risk: Some forms of debt financing require collateral, risking loss of assets in case of default.

Meanwhile, the advantages of equity financing include little or no requirement to use scarce cash to repay the investor. Equity investors are essentially taking on part of the same risk the owner does. They are betting that the business will succeed, and that their stake will be worth more someday. This can make equity financing a good fit for many startups, which lack the track record and financial strength to qualify for loans but have good long-term growth prospects.

However, the cons of equity financing include loss of control. Equity investors will require a share of the profits as well. It also creates the potential for conflict between the investor and original owner of the business.

Pros of Equity Financing	Cons of Equity Financing
No repayment burden: Unlike loans, equity doesn’t have to be repaid, which can ease cash flow concerns.	Reduced ownership stake and profit margin: Selling equity means giving up a portion of ownership, potentially leading to diluted control and profit sharing.
Access to more funds: Especially for high-growth potential businesses, equity can provide substantial capital that might be unattainable through debt.	Possible investor conflict: Investors may have different visions or strategies, leading to conflicts in decision-making.
Additional resources: Investors often bring valuable resources, including industry connections, expertise, and operational guidance.	Valuation challenges: Establishing a fair valuation for equity stakes can be complex and contentious.

Bottom Line

These two sources of financing have significantly different traits and impacts on a business. Which one is best suited depends in part on the business’s age, size, stability, profitability and prospects for growth. The business owner’s personal inclinations toward taking on risk and sharing control are also critical to factor into a decision.

Tips for Business Financing

Consider talking to a financial advisor about debt and equity financing in order to help you make the right individualized decision for your business. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
While some business owners are hesitant to take on debt, it’s important to tell the difference between “good” debt and “bad” debt. Here’s a useful primer on how to tell the difference.