Debt Financing vs. Equity Financing: Which is Better?

Ever had to choose between debt or equity financing? Understand and compare about debt and equity financing now.

debt-financing

So your business needs additional funds for cash flow. The big question is, should you get a business loan or look for an investor? Learning how to finance your business is a very crucial subject that many entrepreneurs fail to grasp, without realizing how dire the consequences could potentially be. So then, which is the better option for raising capital, debt or equity?

Always better to make an informed decision than a rash one. So before we delve into making a decision, here we attempt to explore and understand the fundamentals of both products.

What is debt financing?

By definition, debt financing happens when a company raises capital by borrowing money that is to be repaid with interest at a future date. Funds raised from debt financing are usually for working capital or cash flow purposes. With debt financing, capital can be raised by taking up a bank loan or by the issuing of bonds to either individuals or institutional investors.

Pros of debt financing

  • With business loans, you almost always get full discretion and freedom as to how you want to utilize the funds. However, albeit rarely, there are the rare occasions that restrictions and conditions are imposed.
  • Business loans are temporary and finite; they do not latch onto a company forever. After complete repayment of a business loan, your burden is lifted and business continues.
  • Business financing, in terms of debt financing, is flexible in nature and can be structured to tailor fit a business. There are many different kinds of bond structures and business loan facilities that offer a wide range of quantum and repayment tenures.
  • With bonds, you get the benefits of a business loan, without the struggle of having to repay a monthly Principle + Interest, which can cause a choke in cash flows if not managed properly. With capital that is raised through bonds, where interest pay-outs to investors are typically on a quarterly or semi-annually basis, you get to enjoy the advantage of better cash flows until the maturity date of the bond, where the principle is then repaid.

Cons of debt financing

  • There is a cost for the financing that you receive. However, if properly utilised, the benefits of the additional funds should outweigh the cost of funds.
  • Qualifying for a business loan can often be tedious and frustrating. Entirely dependent on the financial strength of your company and the past credit history of the Directors, it can be difficult to meet all the requirements that qualify your business for your ideal loan amount, tenure, and interest rates.
  • In the event of a default, financiers can either seize the company’s assets or, if the directors stepped in as guarantors for the business loan, then the lenders can go for personal assets as well.

What is equity financing?

Equity financing is the process of raising capital through the sale of shares in a business, where a business owner sells an ownership interest of the company to raise funds.

With the rise of tech startups and companies with innovative inventions or products, equity financing has become an essential part of the industry, such that aspiring entrepreneurs are actually willing to spend years working on a prototype, with the ultimate goal of pitching for investments from venture capitals or affluent individuals, all without a guarantee of being able to raise any capital at all. However, because of the exponential success of tech startups like Facebook and Amazon, it also became a trend for venture capitals and private/institutional fund houses to start searching for the ‘next big thing’, where the returns from investments could skyrocket by thousands of times.

Pros of equity financing

  • With no need to pay a monthly principle sum with interest on capital raised through equity financing, it would essentially mean that you would have more cash flow to put into growing the business.
  • Like any partnership, where both parties first evaluate each other, then proceed to make a conscious decision to collaborate, so it is with investors and investees. Many a times, especially with startups, the right investors could make the world of a difference. If the ideal investor comes along, whether it is a venture capital, a family fund or even an affluent individual, the investor often brings along with them a wealth of experience, wisdom, industry contacts and many other benefits. More often than not, these relationships can for a lifetime.
  • In the fateful event of a business failing, you will not need to repay the amount raised via equity financing.

Cons of equity financing

  • Has the potential to drag on for a very long time before funding is raised.
  • You’re giving away ownership of your business, and with that, decision-making power. You’ll have to consult with investors, and you might disagree over the direction of your company. You might even be forced to cash out and abandon your own business. You have to give away a stake in your business, which also means giving up the right to full autonomy and discretion of every decision.

How to know if which is right for your business?

If ever faced with such a decision to make, here are a few questions that may guide you towards the right choice:

  1. Is the need for financing urgent?

If the need for financing is urgent, then the most logical choice would be debt financing. Compared to equity financing, business loans are way easier and faster to qualify for. Even if delayed, we would be looking at a timeline of about 4 weeks to get the funds. However, with equity financing, the process can often get a little more tedious and complicated. It begins with having to prepare a convincing presentation, then you will have to pitch your business idea to a pool of multiple potential investors, and if well-liked, then there is a process of evaluating and choosing the right investors. After getting interested potential investors on-board, there will be a long and tiring process of drawing up the legal documents and a whole bunch of other processes that will require a timeline of between a few weeks to a few months.

However, let us look at a scenario where the need for financing was not too urgent. Technically, if given ample time, both options could work for you.
Still, the ideal choice would be debt financing, by reason of evaluating the benefits of debt financing against the potential risks and long term costs of giving up equity.
In a perfect world, where all are equal, debt financing should almost always be the preferred choice, where costs and downsides can be measured.

  1. How much capital do you need?

As the old saying teaches us, “Never bite more than you can chew”. If you do not need a substantial amount, or if you are only intending to raise a small amount of capital, then debt financing, in regards to bank loans in particular, is the only logical option. With business loans, even if the banks offered a million dollars, you have full discretion and the right to only take up $100,000 if you so choose to.

If even for a moment, that the idea of early-stage seed investors floated into your mind, then let it fleet away. Early-stage investors typically go for substantial ($300k and above) investments that they think are stable. Sometimes, they even demand for unreasonable stakes in the company. However, if you were running a business model that allowed you to maximize every extra dollar with little to no risks, then the issuance of bonds, or the exchange of equity, or a combination of both cold be good

  1. Other than raising capital, what else are you looking for?

If the focus was purely on fund raising, then debt financing is the obvious choice for you. Debt financing is very transactional and clinical. After getting a business loan, you start paying the monthly installments for a set period of time, until the entire debt is paid in full, and that is it.

On the other hand, equity financing will give you the chance to interact with an investor or several investors even. And through these interactions, you get the chance to access and tap into the minds of investors who have ‘been there and done that’, where you will gain insight into their storehouse of knowledge, experience, contacts, and expertise. More than that, you get to forge a relationship with people who may be able to propel your business to a whole new level. However, if all you were looking to obtain is additional cash flow, then it is best not to get involved with investors at all.

  1. Do you prefer to make business decisions on your own? Or would you rather have others make them with you?

Having sacrificed a significant amount of their lives to build a business with blood, sweat, tears and pure grit, it would seem that most entrepreneurs would not want to lose even a fraction of control over the business. However, with limited finances, most entrepreneurs are forced to trade equity for capital. If that is the case for you, and you have enough finances to continue building and expanding your business, then equity financing is not the path for you.

However, for some entrepreneurs, control and dominance of business directions are just not a part of the evaluations. It could be a case where the entrepreneur is more profit driven than anything else. With such a scenario, the choice should be entirely based on which option will lead the company to greater profits.

  1. Where do you see the company in 5 to 10 years?

The fundamental end goal of all investors is to see capital growth. With most angel investors and venture capitalists, they are always on the lookout for businesses with the potential to grow and expand exponentially, like Facebook, which seemed to almost be an overnight success. If your end goal is similar, where you want to grow your business into a major league global business with, then equity financing could be what you need.

However, the irony is that while the success of Facebook is ever so inspiring, there are many entrepreneurs who just want a simpler life. All they really want is stable business that deals locally, where they feel secure, and have autonomy over the entire business. If you brim with happiness at the thought of a simple life with a small business, then equity financing is not for you.

Therefore, it is highly imperative that you know what kind of financing your business needs, for it can make or break a company. Choosing the wrong kind of financing can turn into a nightmare that you cannot seem to get out of, while on the flip side, the right kind of financing can also propel your business into a global giant. Lastly, do not hesitate to use both options if it fits right for the business.