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 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.

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

In Debt Financing you usually repay in weekly or monthly installments, and you must repay both the loan amount and interest over a specified period. Equity Financing does not require you to repay any amount. Instead, an Equity Financing company will take a share in the future earnings of your company.

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

What's the difference between debt financing and equity financing? Debt financing raises funds by borrowing. Equity financing raises funds from within the firm through investment of retained earnings, sale of stock to investors, or sale of part ownership to venture capitalists.

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

Equity financing involves selling shares of ownership in the company while debt financing does not. Equity financing often involves paying interest while debt financing does not.

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.

Why is debt financing better than equity? ›

Reasons why companies might elect to use debt rather than equity financing include: A loan does not provide an ownership stake and, so, does not cause dilution to the owners' equity position in the business. Debt can be a less expensive source of growth capital if the Company is growing at a high rate.

What is the difference between debt financing and a loan? ›

In corporate finance, debt is more narrowly defined as money raised through the issuance of bonds. A loan is a form of debt but, more specifically, an agreement in which one party lends money to another.

What is equity financing? ›

Equity financing is the process of raising capital through the sale of shares. Companies raise money because they might have a short-term need to pay bills or need funds for a long-term project that promotes growth. By selling shares, a business effectively sells ownership of its company in return for cash.

What is the difference between debt and equity financing which do you prefer and why? ›

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.

What is the difference between equity and debt 3 main differences? ›

Equity Capital is an asset for the company that they show in the books as the entity's funds. Debt Capital is a short term loan for the organisation. Equity Capital is a relatively longer-term fund for the company. A debt financier is a creditor for the organisation.

Which of the following best describes the main differences between debt and equity? ›

Question: Which of the following best describe the main differences between debt and equity? A. Debt does not represent an ownership interest in the firm, while equity generally does represent a share of ownership.

What is the difference between equity and debt? ›

"Debt" involves borrowing money to be repaid, plus interest, while "equity" involves raising money by selling interests in the company. Essentially you will have to decide whether you want to pay back a loan or give shareholders stock in your company.

What is the difference between debt financing and equity financing explain advantages and disadvantages of both types of financing? ›

Debt Financing vs.

The main difference between debt and equity financing is that equity financing provides extra working capital with no repayment obligation. Debt financing must be repaid, but the company does not have to give up a portion of ownership in order to receive funds.

What is the difference between debt and equity investments? ›

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.

What is a equity financing? ›

Equity financing is the process of raising capital through the sale of shares. Companies raise money because they might have a short-term need to pay bills or need funds for a long-term project that promotes growth. By selling shares, a business effectively sells ownership of its company in return for cash.

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

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. Equity Capital is an asset for the company that they show in the books as the entity's funds.

Top Articles
Latest Posts
Article information

Author: Rev. Porsche Oberbrunner

Last Updated:

Views: 6262

Rating: 4.2 / 5 (53 voted)

Reviews: 92% of readers found this page helpful

Author information

Name: Rev. Porsche Oberbrunner

Birthday: 1994-06-25

Address: Suite 153 582 Lubowitz Walks, Port Alfredoborough, IN 72879-2838

Phone: +128413562823324

Job: IT Strategist

Hobby: Video gaming, Basketball, Web surfing, Book restoration, Jogging, Shooting, Fishing

Introduction: My name is Rev. Porsche Oberbrunner, I am a zany, graceful, talented, witty, determined, shiny, enchanting person who loves writing and wants to share my knowledge and understanding with you.