The Difference between Debt Financing and Equity Financing

To borrow, let go of a chunk of the ownership pie, or do neither? Non-equity financing may be your savior. We tell you why!

When a business needs money from the outside to secure its growth, the two generally present options are debt financing and equity financing.

Both of these ways noticeably differ when pumping cash into a business. The most fundamental difference is that while debt financing is about borrowing money, equity financing involves selling a share of the company to an investor.

Neither of the options is an easy choice to make since each has its own merits and demerits. This is why, in this article, we’ll be diving deep into these concepts to help you make an informed decision regarding your business.

So, which is better: equity or debt? Let’s find out :)

What is debt financing?

You probably already know about debt financing if you’ve taken a student/car loan or a mortgage.

Debt financing is the technical term you use to refer to borrowing money from outside sources that needs to be repaid with a decided percentage of interest.

Let’s look at a debt financing example to understand this well. Say a business needs a loan of 10 crores. When choosing debt financing for obtaining this loan, the owner would have to attach some of their firm’s assets. This would help them to get the loan against the asset’s valuation.

When talking about this type of financing, most people's thoughts go straight to the banks. That is because bankers systematically structure big loans. Besides, this option can also turn out to be a good fit for your business if the bank is offering low interest costs and better returns.

Having said that, while mature businesses can genuinely reap the benefits of debt financing,  It  can be more challenging for startups and small businesses to get their hands on sufficient debt financing opportunities.

A new business with poor credit scores or inadequate collateral can have a hard time when it comes to qualifying for debt financing through bank loans. In other words, the eligibility requirements for debt financing through bank loans are stringent.

All is not lost, though; the good news for small business owners is that so many other debt financing options are still available. Some of the popular forms of debt financing include business loans, commercial mortgages, working capital facilities (such as Invoice discounting and overdraft), asset finance, microloans, peer-to-peer loans, and even credit cards.

Advantages of debt financing

Tax deduction and lower rates of interest

More often than not, taxes become the critical consideration for businesses when deciding on whether to use or restrain from trying to seek debt financing. Business expenses include the principal and the interest associated with business loans.

Taking a debt can entail gaining a tax advantage for businesses. When it comes to the lowered interest rates, this advantage accompanying debt financing is a tad bit difficult to understand. However, it is pretty valuable.

This can be more clearly explained with an example. If you're charged 10% interest on a business loan by your bank, with the government setting you 30% on the interest rate and multiplying it by 1-30%, it accounts for 7%. Followed by your tax deductions, you'd pay a 7% interest rate compared to the 10% rate.

Thus, you can see that it's a win-win move. While you gain the incentive to grow your business, you can also help slash your tax rate with debt financing.

Sustain your business ownership

For a growing business, the temptation of finding an Angle Investor can be dominating, given this is an excellent way of infusing cash into your business. Then again, you need to question yourself about whether you're ready for investors' frequent and often muddy interferences.

If you find yourself in a position where you really want to be the one who calls the shots in the business, you need to consider debt financing. Unlike venture capitalists, debt financers won't try to intervene in the decision-making process of your business. Plus, while debt financing can ensure the availability of the money needed for your business, it also entails zero interference from banks or lenders in your business decision-making.

Ease in the planning process

The good thing about debt financing is that you already know the specific amount of principal and the pre-decided interest that you're supposed to pay to the lender monthly. Its specificity ensures better financial planning and budgeting. This means you no longer need to worry about the monthly amount you need to pay your lender.

Disadvantages of debt financing

As fuss-free as it looks, debit financing isn’t all roses and peaches. Here are some of the disadvantages associated with debt financing:

Requirements for qualification

For starters, your credit rating needs to be good enough to secure debt financing. The credit rating is affected explicitly by what you borrow. When borrowing large amounts, the effect on credit ratings can be negative. This attracts higher rates of interest as well as more risks when it comes to the lender.

Collateral

The business assets that you offer as collateral to the lenders can be at significant risk. If you're asked to guarantee the loan personally, it can jeopardize your assets.

Cash flow difficulties

Not many businesses make the exact same (or even similar) sales figures month-on-month. Rather, many of them witness periods that are busier compared to others. However, the lenders expect payments relating to debt financing in terms of equal monthly instalments.

 Needless to say, the obligation of paying the debt regularly can be challenging, often leading to late payments and even payment defaults, harming your credit in the long run.

Simply put: when you're not sure you can make regular payments to repay the debt, getting a loan is certainly not a good idea.

What is equity financing?

To put it simply, equity financing is about selling business shares to raise capital. Contextually, this option is known to be preferable  to businesses when compared to other-  options such as taking a bank loan. The sale can be made to institutional investors, the public, as well as financial institutions. The entities buying the shares of the business are the shareholders, given they now have a claim on the ownership rights of the business.

Venture capitalism is a prime example of equity financing. Venture Capital Financing is all about raising capital by high net-worth individuals looking to diversify their investment opportunities. These individuals offer the much-required capital of businesses in exchange for ownership and share in the business.

Advantages of equity financing

Fewer risks

In equity finance, you don't need to pay anything monthly to secure the money. This makes equity finance a viable option, specifically for startups. This is because startups are often struggling to generate revenues in the early phase of the business.

The ease at dealing with credit problems

Businesses facing credit problems can truly reap the benefits of equity financing, since this does not involve taking out business funding. Compared to debt loans, this option does not end up reducing the money needed for growing and scaling the business.

Ease of long-term planning

Equity investors do not demand immediate returns on investments. Often, they operate with a long-term perception in terms of getting returns. Consequently, they offer businesses the opportunity to consider how they would function in the long run. This can provide a sense of temporary security to the business, nudging it towards growth.

Disadvantages of equity financing

Can be costly

Given that equity investors expect to gain a significant return on their money, your business must share the profits with them, at least to some degree. With this, the amount of profit a business needs to share with its equity partner can be greater when compared to debt financing.

Losing control

To some extent, the control that the owners had over a company before equity finance is reduced after availing the option. This is understandable as now the equity partners want a voice when making strategic decisions for the company, particularly the big ones.

Possibility of conflicts

Ensuring all the partners agree when it comes to making a decision can be difficult goal to achieve on a day-to-day basis. Some of the important areas that require partners to work together include sharing financial decisions, handling money conflicts, and sharing some similar goals as others. Thus, when opting for equity financing, you must be prepared to handle all the differences in the partners’ opinions.

Debt Financing vs. Equity Financing

Debt Financing		Equity Financing
Repayment	The principal and the interest are supposed to be repaid in debt financing over a pre-decided period.	Equity finance does not entail any repayment obligations, thus making it possible to channel more money into your business.
Ownership	Debt financing entails retaining full ownership.	In equity financing, the stakes of your business are bought by equity investors. This leads to decreases in your shareholding. It also means now the investors have some degree of ownership rights on your business.
Security	In many cases, pledging an asset to ensure the security of the loan can be demanded by lenders. In case the borrower fails to repay the loan, the lender can sell the asset to get back the money they invested.	Equity finance doesn’t need collateral.
Access to finance	Say you have started your business with no physical assets or trading history and you don't want to resort to personal assets to secure finance opportunities. In this situation, it can be difficult for you to access the finance for your business with debt financing, specifically when it comes to traditional lenders.	Equity financers often seem willing to back even such high-stake businesses that debt financers consider too high-risk.
Involvement	Given that your lenders don’t have any business ownership, they are not involved in the management's decision-making process.	Equity investors can easily demand board seats to be able to steer business's direction. In other words, they might be willing to bring their insightful opinions, expertise and experiences to the boardroom, leading to considerable involvement in managerial decision-making on their part. For instance, after Walmart invested in the Flipkart Group, Walmart’s executive vice-president of strategy and development, Leigh Hopkins and its chief technology officer Suresh Kumar joined Flipkart’s board of directors. The expertise of these experienced new board members was to help Flipkart make strategic decisions in the Indian eCommerce market.
Fundraising process	If you’re in a hurry to raise capital for your business, debt financing might be the perfect option. The fundraising process is straightforward for the most part and can ensure access to the funds in a matter of a few days or weeks.	The fundraising process for equity financing can be time-consuming. Finding the right investor, negotiating the deal's terms with them, and facilitating the due diligence process can be specifically lengthy, leading to delays in accessing the funds in times of need.

Why companies should choose non-equity financing

If anything, this whole discussion on debt vs equity financing will have shown you that raising money is tough. If you're lucky and raise a round (or even two), one specific risk related to this scenario is diluting your equity stakes.

Now, you should know that there are other options for raising funds without borrowing or selling your equity.

To cite an example, you can consider subscription-based financing options for your firm. As a modern-day non-dilutive funding model, subscription-based financing models can raise capital instantly and offer traction to your company - without diluting the equity of the firm by trading the revenue from a subscription for instant and upfront capital. For investors, the predictability in terms of the maturity of recurring revenue and cash flows makes it roughly the same as a fixed income-generating asset profile.

Any business can avail of the varied non-equity financing options depending on its scope and requirements. Awards, benefits, grants, Small Business Administration loans, crowdfunding, and invoice financing are some of the most effective non-equity financing options that you could look into.

The Bottom Line

May it be debt or equity financing, none of these methods operate on a one-size-fits-all model. For example, a small business aiming at quicker access to capital may find debt financing as the most feasible option, whereas a business requiring bigger cash injection needs to opt for equity financing. Making due diligence to find out which of these might suit your needs better is probably the best thing you can do. Also, don’t forget to consult with your advisors, attorneys, accountants, and other professionals when you make such a critical choice.

If you’re specifically looking for instant upfront capital, our experts at BridgeUp can walk you through these tough terrains. Any firm with high revenue predictability can use BridgeUp.

As India’s first recurring revenue trading platform, we’re happy to introduce you to newer ways of fundraising! Want to know your options better? Call us at +91-9819660287 or drop us a query on the form here.

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• What is Venture Debt? A complete guide to Venture Debt 2022
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