Equity Financing vs. Debt Financing: What's the Difference? (2024)

Equity Financing vs. Debt Financing: An Overview

To raise capital for business needs, companies primarily have two types of financing as an option: equity financing and debt financing. Most companies use a combination of debt and equity financing, but there are some distinct advantages to both. Principal among them is that equity financing carries no repayment obligation and provides extra working capital that can be used to grow a business. Debt financing on the other hand does not require giving up a portion of ownership.

Companies usually have a choice as to whether to seek debt or equity financing. The choice often depends upon which source of funding is most easily accessible for the company, its cash flow, and how important maintaining control of the company is to its principal owners. The debt-to-equity ratio shows how much of a company's financing is proportionately provided by debt and equity.

Key Takeaways

  • There are two types of financing available to a company when it needs to raise capital: equity financing and debt financing.
  • Debt financing involves the borrowing of money whereas equity financing involves selling a portion of equity in the company.
  • The main advantage of equity financing is that there is no obligation to repay the money acquired through it.
  • Equity financing places no additional financial burden on the company, however, the downside can be quite large.
  • The main advantage of debt financing is that a business owner does not give up any control of the business as they do with equity financing.

Equity Financing

Equity financing involves selling a portion of a company's equity in return for capital. For example, the owner of Company ABC might need to raise capital to fund business expansion. The owner decides to give up 10% of ownership in the company and sell it to an investor in return for capital. That investor now owns 10% of the company and has a voice in all business decisions going forward.

The main advantage of equity financing is that there is no obligation to repay the money acquired through it. Of course, a company's owners want it to be successful and provide the equity investors with a good return on their investment, but without required payments or interest charges, as is the case with debt financing.

Equity financing places no additional financial burden on the company. Since there are no required monthly payments associated with equity financing, the company has more capital available to invest in growing the business. But that doesn't mean there's no downside to equity financing.

In fact, the downside is quite large. In order to gain funding, you will have to give the investor apercentage of your company. You will have to share your profits and consult with your new partners any time you make decisions affecting the company. The only way to remove investors is to buy them out, but that will likely be more expensive than the money they originally gave you.

Debt Financing

Debt financing involves borrowing money and paying it back with interest. The most common form of debt financing is a loan. Debt financing sometimes comes with restrictions on the company's activities that may prevent it from taking advantage of opportunities outside the realm of its core business. Creditors look favorably upon a relatively low debt-to-equity ratio, which benefits the company if it needs to access additional debt financing in the future.

The advantages of debt financing are numerous. First, thelenderhas no control over your business. Once you pay the loan back, your relationship with the financier ends. Next, the interest you pay is tax-deductible. Finally, it is easy to forecast expenses because loan payments do not fluctuate.

The downside to debt financing is very real to anybody who has debt. Debt is a bet on your futureability to payback the loan.

What if your company hits hard times or the economy, once again, experiences a meltdown? What if your business does not grow as fast or as well as you expected? Debt is an expense and you have to pay expenses on a regular schedule. This could put a damper on your company's ability to grow.

Finally, although you may be a limited liability company (LLC)or other business entity that provides some separation between the company and personal funds, the lender may still require you to guarantee the loan with your family'sfinancial assets. If you think debt financing is right for you, the U.S.Small Business Administration (SBA)works with select banks to offer aguaranteed loan program that makes it easier for small businesses to secure funding.

Equity Financing vs. Debt Financing Example

Company ABC is looking to expand its business by building new factories and purchasing new equipment. It determines that it needs to raise $50 million in capital to fund its growth.

To obtain this capital, Company ABC decides it will do so through a combination of equity financing and debt financing. For the equity financing component, it sells a 15% equity stake in its business to a private investor in return for $20 million in capital. For the debt financing component, it obtains a business loan from a bank in the amount of $30 million, with an interest rate of 3%. The loan must be paid back in three years.

There could be many different combinations with the above example that would result in different outcomes. For example, if Company ABC decided to raise capital with just equity financing, the owners would have to give up more ownership, reducing their share of future profits and decision-making power.

Conversely, if they decided to use only debt financing, their monthly expenses would be higher, leaving less cash on hand to use for other purposes, as well as a larger debt burden that it would have to pay back with interest. Businesses must determine which option or combination is the best for them.

Special Considerations

Choosing which one works for you is dependent on several factors such as your current profitability, future profitability, reliance on ownership and control, and whether you can qualify for one or the other. The different types and sources for each type of financing are described in more detail below.

Debt Financing

Some sources of debt financing are:

  • Term loans
  • Business lines of credit
  • Invoice factoring
  • Business credit cards
  • Personal loans, usually from a family or friend
  • Peer-to-peer lending services
  • SBA loans

The ability to secure debt financing is largely based on your existing financials and creditworthiness.

Equity Financing

Some sources of equity financing are:

  • Angel investors
  • Crowdfunding
  • Venture capital firms
  • Corporate investors
  • Listing on an exchange with an initial public offering (IPO)

Securing equity financing can be a simpler process than debt financing, but you need to have an extremely attractive product or financial projections, as well as being able to surrender a portion of your company and oftentimes a good amount of control.

Why Would a Company Choose Debt Over Equity Financing?

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.

Is Debt Cheaper Than Equity?

Depending on your business and how well it performs, debt can be cheaper than equity, but the opposite is also true. If your business turns no profit and you close, then, in essence, your equity financing costs you nothing. If you take out a small business loan via debt financing and you turn no profit, you still need to pay back the loan plus interest. In this scenario, debt financing costs more. However, if your company sells for millions of dollars, the amount you pay shareholders could be much more than if you had kept that ownership and simply paid a loan. Each circ*mstance is different.

Is Debt Financing or Equity Financing Riskier?

It depends. Debt financing can be riskier if you are not profitable as there will be loan pressure from your lenders. However, equity financing can be risky if your investors expect you to turn a healthy profit, which they often do. If they are unhappy, they could try and negotiate for cheaper equity or divest altogether.

The Bottom Line

Debt and equity financing are ways that businesses acquire necessary funding. Which one you need depends on your business goals, tolerance for risk, and need for control. Many businesses in the startup stage will pursue equity financing, while those already established and those who have no problem with debt and possess a strong credit score might pursue traditional debt financing types like small business loans.

Equity Financing vs. Debt Financing: What's the Difference? (2024)

FAQs

Equity Financing vs. Debt Financing: What's the Difference? ›

Debt financing refers to taking out a conventional loan through a traditional lender like a bank. Equity financing involves securing capital in exchange for a percentage of ownership in the business.

What is the difference between equity financing and debt financing? ›

There are two types of financing available to a company when it needs to raise capital: equity financing and debt financing. Debt financing involves the borrowing of money whereas equity financing involves selling a portion of equity in the company.

What is the difference between debt financing and equity financing Quizlet Everfi? ›

What is the difference between debt financing and equity financing? Equity financing involves selling shares of ownership in the company while debt financing does not.

What is the difference between equity and debt financing PDF? ›

equity, debt is the issuing of bonds to finance the business while equity is the issuing of stocks to finance the business. Debt financing is the raising of funds through loans, overdraft, debenture, and bonds at a cost which is usually referred to as interest an as coupon rate in the case of bonds.

What is the difference between debt and equity funds? ›

Debt Vs Equity Fund. Debt funds offer stable returns with lower risk, while equity funds have the potential for higher returns but higher risk. Debt funds generate income through interest, while equity funds generate income through dividends and capital gains.

Does equity financing have to be repaid? ›

With equity financing, there is no loan to repay. The business doesn't have to make a monthly loan payment which can be particularly important if the business doesn't initially generate a profit. This in turn, gives you the freedom to channel more money into your growing business.

What are the pros and cons of equity financing? ›

Pros & Cons of Equity Financing
  • Pro: You Don't Have to Pay Back the Money. ...
  • Con: You're Giving up Part of Your Company. ...
  • Pro: You're Not Adding Any Financial Burden to the Business. ...
  • Con: You Going to Lose Some of Your Profits. ...
  • Pro: You Might Be Able to Expand Your Network. ...
  • Con: Your Tax Shields Are Down.
Apr 18, 2022

Which is true of debt versus equity financing? ›

Debt Financing can be more suitable for short term needs (e.g working capital) and for established Businesses who can be sure they can meet the financial commitments. Equity Financing can be more suited for startups or growth-oriented Companies where cash flow may not be certain or expected for a while.

Which of the following is a difference between debt and equity capital? ›

Debt Capital is the borrowing of funds from individuals and organisations for a fixed tenure. Equity capital is the funds raised by the company in exchange for ownership rights for the investors. Debt Capital is a liability for the company that they have to pay back within a fixed tenure.

Which of the following is a difference between debt and equity capital quizlet? ›

Debt capital requires returns in proportion to profits, whereas equity capital requires a fixed rate of return.

Which is better debt or equity? ›

Since Debt is almost always cheaper than Equity, Debt is almost always the answer. Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders' expected returns are lower than those of equity investors (shareholders). The risk and potential returns of Debt are both lower.

What is the difference between debt and equity interest? ›

When financing a company, "cost" is the measurable expense of obtaining capital. With debt, this is the interest expense a company pays on its debt. With equity, the cost of capital refers to the claim on earnings provided to shareholders for their ownership stake in the business.

What is debt financing? ›

Debt financing is the act of raising capital by borrowing money from a lender or a bank, to be repaid at a future date. In return for a loan, creditors are then owed interest on the money borrowed. Lenders typically require monthly payments, on both short- and long-term schedules.

What are the key differences between debt and equity financing? ›

Debt financing refers to taking out a conventional loan through a traditional lender like a bank. Equity financing involves securing capital in exchange for a percentage of ownership in the business.

What is the difference between debt and equity in the financial market? ›

Debt and equity are the two main types of finance available to businesses. Debt finance is money provided by an external lender, such as a bank. Equity finance provides funding in exchange for part ownership of your business, such as selling shares to investors.

What is debt vs equity financing investment banking? ›

Equity financing involves raising capital by selling equity in your company. This means investors provide funds in exchange for ownership interest or equity. Unlike debt financing, where loans must be repaid with interest, equity financing secures money without incurring debt.

What are the pros and cons of debt financing? ›

Pros of debt financing include immediate access to capital, interest payments may be tax-deductible, no dilution of ownership. Cons of debt financing include the obligation to repay with interest, potential for financial strain, risk of default.

What is a good debt to equity ratio? ›

Generally, a good debt ratio is around 1 to 1.5. However, the ideal debt ratio will vary depending on the industry, as some industries use more debt financing than others.

What is the difference between debt financing and equity financing brainly? ›

Equity financing means selling shares and part of the ownership in a company, sharing risks and rewards with the new investors, while debt financing involves borrowing funds, committing to paying interest, and retaining full control and ownership.

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