Debt vs. Equity Financing: Which Is Best for Your Business? - NerdWallet (2024)

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Small-business owners generally have two basic funding options: debt financing and equity financing.

Debt financing is when you borrow money, often via a small-business loan, which you repay with interest. Equity financing is when you take money from an investor in exchange for partial ownership of your company.

Both options provide cash for your business, but each has pros and cons. Debt financing allows you to maintain full control of your business but can be expensive, especially if you have bad credit or haven’t been in operation long. Equity financing is an option for startups and pre-revenue businesses but requires giving up a stake in your company to investors who may want to influence business decisions.

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Debt vs. equity financing overview

Debt financing

Equity financing

Set monthly or weekly payments.

No repayment schedule. Investors earn a share of the business's profits.

Qualification typically based on business financials and personal credit score.

Qualification typically based on business potential and owners' character.

Interest required.

No interest required.

Maintain full ownership of your business.

Trade percentage of ownership for funds.

Available from banks, credit unions, online lenders and some nonprofit lenders.

Available from angel investors, crowdfunding platforms and venture capital firms.

When to choose debt financing vs. equity financing

The best financing for your business will be the one that supports your company’s goals and financial needs, now and in the future.

Consider debt financing:

If you can qualify

Getting a business loan isn’t always easy, especially for startups in need of financing. Lenders often require a certain length of time in business, solid credit, strong financials and some type of collateral. If you meet those criteria, you may get a competitive interest rate.

If you expect a positive return

A loan can be a good financial move for your business if you are intentional about its purpose and your projected returns are greater than the total interest you’ll pay. Another positive: Repaying debt can build your business credit, which can lead to better rates and returns in the future.

If you’re comfortable with the risk

If you put up collateral, failing to repay the debt could cost you that asset. Even if the debt is unsecured, your credit score will be at risk, and items like your home or car could be too if the lender requires a personal guarantee.

If you want to maximize your money

Debt financing may have more long-term financial benefits than equity financing. With equity financing, investors will be entitled to profits, and if you sell the company, they’ll get some of the proceeds too. This reduces the amount of money you could earn by owning the company outright.

» MORE: How to apply for a small-business loan

Consider equity financing:

If you want to avoid debt

Equity financing may be less risky than debt financing because you don’t have a loan to repay or collateral at stake. Debt also requires regular repayments, which can hurt your company’s cash flow and its ability to grow.

If you’re a startup or not yet profitable

Equity financing may be necessary if you can’t qualify for a startup business loan and want to avoid more expensive options like credit cards. Just make sure the investment is a fair valuation since your business is young.

If you can find a partner or mentor

Investors can offer working capital to build your company. But their industry knowledge or experience could prove just as valuable, especially if they take an active role in your business’s growth and success.

If you’re OK giving up some control

An investor who owns a large-enough stake is entitled to voting rights and could insist on actions like electing new directors. If you eventually give up more than 50% of ownership, you can lose complete control of your company. To regain it, you’d likely have to buy out investors — which may get expensive.

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Debt financing options for small businesses

If you want to finance your company with debt, here are some common types of small-business loans:

  • Term loans can have high borrowing limits and may be a good choice if you’re looking to expand and have good credit and strong earnings.

  • Business lines of credit offer a flexible way to meet short-term financing needs — for example, if you need to purchase inventory or fix broken equipment.

  • Invoice factoring can turn unpaid invoices into fast cash and may be an option for startups with bad credit because the invoices themselves act as collateral.

  • Personal loans for business are another option for new businesses that want to hang on to equity, but rates depend on your credit score and can be expensive.

  • Business credit cards can help cover ongoing expenses and may be necessary if you’re a startup that can’t qualify for a loan.

» MORE: Business credit cards vs. business loans

Equity financing options for small businesses

Here are some small-business financing options that can rely on equity:

  • Venture capital may come from a single person or a firm that invests from a pool of money. VCs are more likely to offer financing to established businesses than startups and will often require a seat on the board of directors, plus equity.

  • Angel investors are individuals who use their own money to offer businesses financing. They typically invest in startups with high earning potential, which means they may be more likely to take a risk if the return looks promising.

  • Equity crowdfunding is a process of raising capital from a “crowd,” or group of investors. This can be a good option for smaller businesses or those who are wary about pitching directly to an angel investor or venture capitalist. Investors can view and select business profiles to support directly via the online crowdfunding platform.

  • Family and friends. Getting in front of a VC or angel investor can be difficult; earning an investment is even harder. You may have better luck getting equity financing from family and friends. But if you lose their money, your relationship could be at risk.

Frequently asked questions

What is the difference between debt financing and equity financing?

Debt financing involves taking out loans, which are lump sums given by a lender to be repaid over time with interest. Equity financing involves trading equity, or ownership, in your business in exchange for capital.

What is the difference between debt and equity?

In short, debt refers to money that you owe a lender, while equity simply refers to shares of ownership in a business.

What is riskier, debt or equity?

It depends on the business. Debt can be risky if monthly or weekly payments get on top of you and restrict your cash flow. Equity financing can be risky if you give up too much control of your business.

Debt vs. Equity Financing: Which Is Best for Your Business? - NerdWallet (2024)

FAQs

Which is better for your business debt or equity financing? ›

Debt financing can offer the means to grow without diluting ownership, while equity financing can provide valuable resources and partnerships without the pressure of repayment schedules. Remember, the best choice is one that aligns with your startup's unique circ*mstances and future aspirations.

Do companies prefer debt or equity? ›

A company would choose debt financing over equity financing if it doesn't want to surrender any part of its company. A company that believes in its financials would not want to miss on the profits they would have to pass to shareholders if they assigned someone else equity.

What is the best financing option for a business? ›

If you want the most affordable type of debt financing and you have strong qualifications, a bank or SBA loan might be your best option. On the other hand, if you're a newer business or have fair credit, an online loan might be a better route.

Why would an entrepreneur prefer debt financing over equity financing? ›

Many fast-growing companies would prefer to use debt to support their growth, rather than equity, because it is, arguably, a less expensive form of financing (i.e., the rate of growth of the business's equity value is greater than the debt's borrowing cost).

Why use equity instead of debt? ›

Equity financing may be less risky than debt financing because you don't have a loan to repay or collateral at stake. Debt also requires regular repayments, which can hurt your company's cash flow and its ability to grow.

Is debt financing good for small business? ›

The key benefit of debt financing is control. Rather than giving away a share of your company to secure investment, you retain 100% of your business. This means you can develop your business without outside influence, and you're not railroaded into focusing on growing shareholder value or generating profit.

How to choose between debt and equity financing? ›

Key Takeaways

Debt financing could save money but demands collateral and returning the money soon. Equity financing removes payback worries but may reduce your control and ownership. Traditional loans offer better rates compared to expensive merchant cash advances.

What is a disadvantage of equity financing? ›

Equity Financing also has some disadvantages as compared to other methods of raising capital, including: The company gives up a portion of ownership. Leaders may be forced to consult with investors when making a decision. Equity typically costs more than debt financing due to higher risk.

Which is more risky debt or equity for a company? ›

Debt financing is generally considered to be less risky than equity financing because lenders have a legal right to be repaid. However, equity investors have the potential to earn higher returns if the company is successful. The level of risk and return associated with debt and equity financing varies.

Which is a riskier form of financing for a business? ›

Unsecured Business Loans: This type of loan does not require collateral and is also called a line of credit loan. These loans are riskier for lenders due to no collateral as a repayment guarantee. Due to this risk, the loan amounts are smaller, and the interest rates are higher.

What is the cheapest source of finance for a new business? ›

Shareholders funds refer to equity capital and retained earnings. Borrowed funds refer to finance raised as debentures or other forms of debt. Retained earnings are the part of funds which are available within the business and is hence a cheaper source of finance.

What is the best financing method for beginning entrepreneurs? ›

If a new business idea doesn't yet meet the criteria for business financing, entrepreneurs could consider using a personal loan (as long as the lender permits using funds for business purposes) or credit card to fund the project. In this case, lenders will only review the borrower's credit and income.

Is debt financing good for startups? ›

Long-term debt is almost always the better option for a startup that needs to fund its runway for growth. Short-term debt can be a good solution in certain scenarios but is typically less advantageous.

Why is debt financing better? ›

One advantage of debt financing is that it allows a business to leverage a small amount of money into a much larger sum, enabling more rapid growth than might otherwise be possible. Another advantage is that the payments on the debt are generally tax-deductible.

Which is a disadvantage of debt financing? ›

You must pay back the loan at the terms agreed upon. That means, even if your business goes under, you still have to make payments. Since most lenders require you to guarantee the loan, your assets could be sold to satisfy your debt.

What is the main difference between debt and equity for the business owner? ›

With debt finance you're required to repay the money plus interest over a set period of time, typically in monthly instalments. Equity finance, on the other hand, carries no repayment obligation, so more money can be channelled into growing your business.

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