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Differences Between Debt and Equity Financing: which is right for you?

March 1, 2019 / NEWS

Differences Between Debt and Equity Financing: which is right for you?

If you’re looking to grow your company quickly and wish to seize new opportunities now, then you will need some sort of finance. Two of the main choices you have are debt financing and equity financing. Depending on the position your business is in and how much control you wish to lose, you will need to think carefully about which is right for you.

So, what is debt financing exactly?

Debt financing occurs whenever you secure funds in exchange for an agreement to pay back the principal amount plus interest. The exact nature of your debt deal can differ quite dramatically and will depend largely on how risky your business is, how much you need to access and how risk-averse the lender is. The key thing to note with debt financing is that you are not giving away any of your company.

Instead, the lender is purely interested in eventually receiving back the amount lent to you, plus interest for the time and risk associated with the loan. You can receive debt finance either with or without offering up some form of security and depending on which you choose, the loan terms will also vary.

What is equity financing?

Equity financing occurs when you sell some portion of your company to a lender. Essentially, the funds you receive come in exchange for you sacrificing control of some part of your company. Exactly how much you lose depends entirely on the individual agreement. But the key part of the deal is that the lender is then financially invested in your company.

It is in their best interest for your company to succeed, or else they will see no return on their investment. Any returns they do see could come via an increase in your company’s stock price or through dividends. If you ever wish to regain that portion of your company, you would need to buy it back from the lender or whoever owns the shares at that time.

The key differences between debt and equity financing

Now that you have a more solid understanding of what each type of finance is, it’s time to dig a little deeper into the exact differences between debt and equity financing. So here are 6 key categories by which to assess each one.

Returns to the lender

With debt financing, the lender sees returns in the form of the interest you are obligated to pay as per your agreement. With equity finance, it comes in the form of dividends or from one day selling the shares they hold for a higher price.

Need for collateral

There is no need for collateral with equity financing. With debt, you can seek a loan that is either backed by collateral or not. The amount you need to repay might be lower if you do put up some form of collateral.

Difficulty in securing

This depends largely on the nature of your business and the amount you are wishing to secure. For small business loans, you might be more successful in receiving this quickly form a bank under a standard loan agreement.

The risk to the lender

Equity financing is generally considered riskier for the lender, as there is no guarantee when they will see a return on their investment and by how much.

How it helps the business grow

Debt financing can potentially restrict growth after initial funds have been spent and growth hadn’t been as expected. However, there is no such risk with equity finance. Instead, you may also gain experience and advice from investors as well, depending on who it is you secured the finance from and how active they wish to be in your company.

Long term vs short term

Equity finance is considered more of a long term finance option as the investor will likely remain a partner in your company for a number of years. Whereas debt finance agreements may be over in as little as 1 or 2 years.

Ultimately, there is no reason to suggest either type of finance is better or worse than the other. Instead, it means taking a strategic look at your company’s existing financial state and knowing exactly why it needs the influx of capital. It does help, however, to know the exact differences between debt and equity financing before you start speaking to private lenders.

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