Founders and operators face many difficult and important decisions in their line of work; and where to source financing for operations and growth is one of the most important.
Debt and equity are high-level classifiers of the various funding sources but each has a number of options, from the traditional routes like banks and financial institutions to the modern day methods like crowdfunding and peer-to-peer lending.
In this article, we compare and contrast debt versus equity including the various types, advantages, disadvantages, and examples of each.
Debt vs Equity Financing
Whether your business operates in the public or private markets, there are two high-level sources for financing: debt and equity.
What’s the difference between debt and equity?
Debt financing is when a company borrows money to allocate towards productive assets, and repays the loan plus interest, while equity financing is the sale of shares in the company for funding that can be used to appreciate the value of the company’s underlying equity.
If your company is publicly traded, that means you’ve already raised equity financing through your initial public offering (IPO) – but you can also raise subsequent equity capital through the issuance of additional shares.
Publicly traded companies can also raise debt financing when needed and when fiscally responsible. Fiscal responsibility is important because unsustainable debt levels can negatively impact valuations of the equity.
Private companies can access equity and debt financing, as long as it’s not from unaccredited investors in public markets.
An important metric many owners, operators, and investors look at to measure the financial health of a business is the debt to equity ratio:
The lower the D/E, the more fiscally conservative the business has been with taking on debt and vice versa. Depending on the nature of the business, such as in real estate, debt is a very widely-used and understood component of the business model.
Types of Debt Financing
Debt, also known as leverage, is when you borrow money from another party in hopes of investing in productive assets that will provide you with more than enough value to justify the interest charged on the loan.
A loan’s cost of capital is whatever interest rate is charged on the principal amount which incentivizes the institution to loan out their money. Typically, the interest rate is fixed and debt servicing payments are made regularly.
1. Bank Loans
The most commonly used form of debt for businesses is loans from a bank. The review and approval processes for a bank loan can be difficult and unsuccessful, depending on how long the business has been active, the credit ratings of key persons, available collateral, and more. If approved, analysts at the bank will measure the risk of loaning your business the money and calculate a fair (their words) risk-to-reward interest rate.
2. SBA Loans
The US Government’s Small Business Administration provides partial insurance on SMB loans to incentivize lender support for small businesses despite their elevated risk of default. These loans can be used for working capital requirements, purchasing equipment and other fixed assets, growth, or even startup costs via microloans.
The SBA offers support on loans anywhere from $500 to $5.5 million but strives to be the lender of last resort, requiring businesses to “exhaust financing options,” before approaching them for assistance.
3. Business Line of Credit vs. Business Credit Cards
A line of credit and credit card are similar but have some key differences. A typical line of credit is structured with a draw period, where you can withdraw capital as needed and make nominal payments on the interest. After a set period of time, the repayment period begins and payments on the principal line of credit come due.
Credit cards, on the other hand, function more in the draw period, with no set repayment period. Business credit cards can be beneficial in some ways, including cash back on certain purchases and low introductory interest rates, but if repayment is not prioritized it can end up being a very expensive source of capital.
The benefit of these methods is that you only pay for what you use. The downside is that they can come with steep Annual Percentage Rates (APR).
4. Invoice Factoring and Purchase Order Funding
Invoice factoring is when a business sells their invoices at a discount. Essentially, this allows the business to get less cash in the short-term instead of waiting for their account receivables to mature. This type of debt instrument is typically used as a method for bridging severe cash flow constraints.
When a business’s cash is tied up in inventory, one method for financing new business is through purchase order funding. In these scenarios, the business brings confirmed purchase orders from interested parties and the lender provides the funds to pay for the materials, manufacturing, and anything else needed to service the order.
Types of Equity Financing
Equity is the intrinsic value that would be returned to shareholders if the underlying assets were liquidated and liabilities deducted. Equity in a company, for example, represents the assets, both tangible and intangible, and can grow in value linearly or even exponentially as the company grows. Equity ownership is typically represented by physical shares or stock certificates from the corporation.
When financing a business, owners and operators seek to raise equity capital from a number of sources and for a number of reasons we will discuss shortly.
1. Angels and Venture Capitalists
One of the most well known channels for raising equity capital is through an angel investor or venture capitalist. It’s also worth noting that you could raise equity capital from friends and family, usually in the very early stages of a company’s formation and before approaching angels or VCs.
Typically, the younger the company, the more equity will be required to compensate investors for their risk, understanding that their principal investment could easily go to zero if the company fails.
2. Private Equity
David Rubenstein, infamous private equity investor and founder of The Carlyle Group, has described the PE industry as an evolution in terminology, “originally called ‘bootstrap deals,’ because you were bootstrapping yourself to the deal, they later became ‘leveraged buyouts’ but the word leverage became odious so they called them ‘management buyouts,’ and then buyout became an unfriendly word so they landed on ‘private equity.’”
Today, private equity is a method for established businesses to raise money, while the PE investors may put their own equity in the deal, they typically assume large amounts of leverage (debt) to fund their deals, therefore assuming large amounts of risk. Private equity investors will typically want to be included in the decision making and operations to ensure the growth of their investment.
Essentially, your private equity investors raise debt so you can subsequently raise equity capital from them.
3. Equity Crowdfunding
As of 2015, non-accredited and accredited investors alike have been able to participate in equity financing rounds through reg CF crowdfunding campaigns. In equity crowdfunding, as opposed to rewards- and debt-based crowdfunding, investors receive shares in the company as a percentage of total equity.
Equity crowdfunding has democratized the return on equity in private markets that was historically reserved for high net worth individuals and institutions.
Bonus: Convertible Notes
Essentially a middle ground between debt and equity is the convertible note instrument. The convertible note has gained popularity in early stage fundraising because it allows investors and entrepreneurs to close the deal in the short-term, deferring valuation negotiations to the next formal round of financing, where the debt converts to equity.
Advantages of Debt
Depending on the stage and financial health of the company, raising debt capital can be the most advantageous financing method. Let’s explore why debt financing might be your best option.
Unlike equity financing, no shares of equity are exchanged when debt is acquired and therefore the existing capitalization table remains unchanged. The founders and other existing shareholders will retain their full future upside when debt is assumed.
2. Retain Control
Although the lending institution will require intimate knowledge of your business’s financial status, they won’t have control or actively participate in operations or decision making. Unlike equity financing, where voting rights are usually passed on to the equity purchaser, holders of debt only benefit from the terms specified in the loan agreement which usually does not involve voting rights.
3. Capped Risk
When you raise debt financing, the amount of money you will potentially spend in order to achieve your goals for raising the money is fixed and finite. The debt, denominated in dollars, will only fluctuate if the value of the dollar changes or if payments are deferred and accrue more interest.
Disadvantages of Debt Financing
Debt is a fantastic channel for raising capital when the business is experiencing hockey stick growth without as much as a hiccup in operations or change in the macro environment. Unfortunately, this does not accurately portray the experience of most businesses.
1. Risk of Default
In the event of an economic downturn or another existential threat resulting in significant decreases in revenues, the business may be unable to service their debt and put it at risk of defaulting.
2. Risk of Bankruptcy
A company that is accustomed to borrowing money to cover cash flow constraints on operations can also experience a tightening supply of available funds and therefore lack the necessary funds to operate, risking bankruptcy.
Advantages of Equity
There are many advantages for raising equity financing, especially in the early stages of growing a company, when the future is uncertain and cash flow must be prioritized.
1. Less Short-Term Risk
In debt financing, the loan must be repaid within a specified time, whether or not the business reaches financial stability. Debt can present unnecessary risk to young companies that equity financing avoids.
Equity capital typically does not have a specified period for repayment while the debt servicing payments detract from the company’s financial well-being, equity financiers can actually help a company weather any periods of financial instability.
2. Cash Flow Conscious
If your business model is dependent on cash flow management to keep the figurative lights on, regular debt repayments could put strains on your cash flow statements. In debt financing, one person’s asset (debtee) is another person’s liability (debtor). When a company assumes debt, they assume liability for making regular payments.
3. Capped Downside
One of the biggest benefits equity financing offers entrepreneurs is a cap on downside exposure. Equity investors are interested in long-term capital appreciation and therefore do not receive any compensation until the company is either profitable or acquired. If the company fails to turn a profit, or fails entirely, the equity investors will only be entitled to an equitable distribution of any liquidation proceeds.
In other words, your equity investors assume an equal share of risk and will only profit when the company profits.
Disadvantages of Equity Financing
Equity financing is ideal for many businesses because there is no obligation to repay the money but it is not without disadvantages entirely.
1. Money left on the table
From the perspective of the original equity holder, the future value of the equity you sell to raise money in the short term is hypothetically uncapped. Unlike with debt financing, where the principal and interest are established upfront and therefore capped, the equity could be worth a whole lot more than the amount raised in equity financing.
2. Voting Rights
Unlike debt financing where the lenders expect only to get their loan repaid with interest, equity financiers expect their ownership in the company to include voting rights and a voice in the high-level decision making.
If there is disagreement between the operators and equity investors, this can be a disadvantage, but in other cases the investors might provide valuable expertise and insights that help arrive at a strategy that is advantageous for the company.
Should You use Equity or Debt to Finance your Business?
While the ultimate decision will be in your hands, we hope to have provided a helpful overview of both debt and equity financing. It might also be helpful to know that most businesses today have used both equity and debt to finance their growth at one point or another.
Uber, Airbnb, and many other high-growth companies got their start with equity financing from angel investors and venture capitalists only to later raise debt financing and retain their valuable equity.
Despite what our name evokes, you can raise both equity and debt through thousands of investors active on EquityNet. While the majority (69%) of the deals enabled by EquityNet are in the form of equity, many have raised debt rounds through EquityNet.