What is Debt Financing?
Debt financing is when your company raises working capital by selling debt instruments. What are debt instruments? They’re binding obligations that provide funds in return for a contract. A credit card, credit line, loan, or bond – these can all be types of debt instruments. The “contract” includes all the details regarding interest, payments and timeframe.
Simply put, debt financing is the same as getting a loan to start or operate your business. You pay the loan back with interest, and the terms depend on who’s lending it to you.
So with debt financing, it means you’d finance your business through these debt instruments. When you issue something like a bond, investors buy the bonds, and technically become lenders. They’re providing the financing, and you repay this “investment loan” back at an agreed-upon date in the future. If your company doesn’t succeed, the lenders have more of a claim over your assets than a shareholder would – and that brings us to equity financing.
What is Equity Financing?
When you fund your company through equity financing, it means you’re creating shareholders. By selling shares, you sell ownership in your company in return for cash, similar to selling stocks. It can come from several different sources – friends and family, investors, or an initial public offering (IPO). this will often, however, depend on the stage of a company. Startups will use different types of equity financing depending on the stage of funding they’re in.
Types of equity financers are angel investors or venture capitalists. There’s also equity crowdfunding. Equity financing is ofter more important for certain types of startups, like technology or finance companies.
So What’s the Difference?
Debt financing means you have to pay your lender back in cash, plus the interest they’ve decided to charge. You’re obligated to pay this back, even if your business goes belly-up. Equity financing means that instead of paying shareholders back in cash, you share your company’s profits with them, and you make business decisions with them.
Pros of Debt Financing
- You don’t have to share your company with anyone, and you can make all the business decisions yourself. In fact, once you pay the loan back, you don’t have to worry about the lender anymore.
- You’re also in control of how the money is spent.
- Loan interest is tax-deductible, so you don’t have to pay taxes on it when tax season comes around.
- It’s relatively easy to predict and plan for loan payments because they’re the same every month. This way, you’re not hit with unexpected costs and you know exactly how much of your revenue is going toward paying back your financers.
- There are government-backed loan programs with the SBA, and they offer loans with significantly better rates.
Cons of Debt Financing
- The first word is often a con: debt. Debt isn’t always a bad thing, but it means that you’re using money you don’t technically have.
- The fixed-payments could get in the way of growth. Because loans don’t care if you didn’t make as much as you did last month or if business is slow, the payments can really cut into your revenue. If there’s an economic downturn, or if patterns of commerce change, you still have to pay the loan back on a regular schedule, or else they could come for your property.
- And that brings up another downside – many lenders require collateral. If you default or if your company goes out of business and you can’t pay the lender back, they’ll seize your personal or company property – things like your real estate, equipment or vehicles.
Pros of Equity Financing
- You don’t technically have to pay anyone back. Naturally, you want your business to have a good return on investment, but there are no required payments to investors. They’re taking the chance on you and they’re investing because they believe in your company, and that’s their obligation, not yours.
- You’ll have more capital available to grow your business if you don’t have to pay set amounts each month.
- Equity financing is based on percentages, so profit-sharing fluctuates with revenue and isn’t a set amount.
- It helps you build relationships because investors can act as mentors and give you advice on how to steer your business in the right direction.
Cons of Equity Financing
- You don’t have full ownership of your company. In order to get funding from investors, you have to hand over a percentage of your company. This means you share profits and business decisions. You can remove investors by buying their share, but that’s often way more expensive.
- You’re not in full control of how the money is spent, and you have to consult with investors about the direction of your company.
- It takes a lot longer than debt financing – you have to meet with investors and pitch your company.
So Which is Better?
There’s no definitive answer because it all depends on your company’s type and profile. Most companies finance with a mix of both, because they’re both valid and popular ways to fund early businesses. But here’s a guide to help:
- Do you need money fast? Debt financing isn’t instant, but it’s quicker than equity financing. You go through the underwriting process and then depending on if you’re approved or not, you can have the money without having to go through a lot of meetings or company pitches. Equity financing requires a lot of time and effort to prove your worth to investors.
- Do you need a lot of money? Equity financing is useful if you need a significant amount of money – around $300,000 or more. You can use debt for this as well, but equity gives you a way to fund and not worry about paying it back.
- Do you need mentorship? Equity is best if you want a little bit more direction for your business. If you believe in your ideas, but don’t quite know how to execute them, investors often offer mentorship and knowledge – after all, they are now partial owners of your company and want to see it succeed. Investors are usually not strangers to helping companies grow, and will know all the ins and outs.
- What’s your business sector? If you’re trying to start a restaurant or a bar, you might want a lot of control with what’s going on, and won’t want to have to worry about listening to your investors. If you’re running a tech company, the tech world can get complex and has a lot of faucets and barriers to entry, so sometimes it’s better to use investment money and let someone help you map out your route.
- Do you want to scale? Equity firms are looking for people who want to get huge and grow beyond their locality. They probably would love for you to exit the market – that’s when they get big checks. If you’re looking to start a local business, debt financing might be better. If you want to expand beyond geography, equity financing might be better.
FaaSfunds offers credit monitoring for debt financing. If you’re interested in financing your business through loans or other forms of debt, reach out to us today.