What are the differences between debt financing and equity financing?

Most small businesses face a choice in funding: debt financing or equity financing. Debt financing means borrowing money, while equity financing involves giving away a portion of your business in exchange for funds. Understanding the difference is essential, as the decision can be complex. If you give away too much equity, you risk losing control of your operation. If you take on too much debt, you may struggle financially. Let’s explore the key factors to consider when weighing up debt versus equity financing.

What is equity financing?

Equity financing is a way of raising money for your small business without taking on debt. Instead of borrowing money from a lender, you receive funding in return for shares – also known as equity – in your business.

These investors then become shareholders, meaning they own a stake in the business. Examples of the types of equity finance investors include:

• Venture capitalists – individual investors or firms that provide funding to early-stage companies and startups with high growth potential

• Angel investors – akin to venture capitalists, but they tend to be high net-worth individuals who get involved at an earlier stage and usually offer up less cash

• Private equity firms – investment management companies that raise funds from investors to invest in private companies

• Crowdfunders – accessible through online crowdfunding platforms, crowdfunding investors offer funding in return for shares in your business (or other types of rewards on platforms like Kickstarter) 

• Family and friends – you could choose to give loved ones a stake in your business in return for money

You can mix and match different equity finance options. For example, a family member could invest £20,000 in exchange for a few shares, while an angel investor might contribute £200,000 for significantly more. It’s crucial to understand the value of your business in these scenarios.

In this case, the family member wouldn’t receive the same percentage of ownership as the angel investor. Knowing how much equity to give away is key. If you miscalculate, you risk giving away more than the overall value of your business. Just look at how angel investors react on shows like Dragons’ Den to see the importance of getting your numbers right.

Pros and cons of equity financing 

Equity financing has its advantages and disadvantages so it’s important to consider what you need and what you’re willing to give up in exchange. 

Here are some key pros and cons:

Pros

• No repayment required. Unlike traditional debt, you don’t have to repay equity finance. This improves monthly cash flow and gives you more control over day-to-day business operations.

• Access to larger sums of money. Selling your vision to an investor may help you access more money than through traditional lending options. This is especially true if you’re just starting out when lenders might be more cautious.

• Expertise and contacts. If you can get a knowledgeable and experienced investor on board, it’s not just cash you get. Access to their expertise allows you to learn from their mistakes. They may even fast-track your idea through their contacts and networks.

• Shared risk. More people with a stake in your business means the risk is no longer on your shoulders alone. This can protect your business from unexpected challenges. 

• It’s about you. Traditional lending is generally a faceless process. An investor, on the other hand, is looking to invest in you as much as in your idea, so let your personality and passion shine through to make the most of this more personal relationship.

Cons

• Diluted ownership. The more shares you give away, the less control you and other investors have. Diluted ownership influences decision-making and efficiency.

• Pressure. An investor, particularly an angel investor or a private equity firm, may take a very hands-on approach to your business and its operations. They may request regular updates or insist that you pursue short-term gains so they can recover their investment more quickly.

• Less profit. Investors may insist on profit sharing. This might seem like a good idea in the early days, but as your business grows, the profits you make may need to go straight back to them, reducing the amount you have to reinvest in growth.

• Costs. While you don’t need to worry about interest or monthly repayments, equity finance still comes with legal and administrative costs that need to be considered.

• Personality clashes. The relationship between a business owner and an investor can be close, which may lead to tension or even conflict if they disagree on business decisions.

What is debt financing? 

Debt financing is a way of raising money by borrowing (or taking on debt). This is a very different prospect to equity finance insofar as you access the funding you need while retaining sole control of your business.

You can get this type of business funding in a variety of ways – common examples include:

• Loans. This is a common form of debt financing where a business borrows an amount which it repays over a set term with interest

• Government schemes. The Start Up Loan Scheme allows small businesses to borrow up to £25,000 and pay a fixed rate of interest at 6%

• Peer-to-peer lending. With this type of funding, you borrow from several non-traditional investors through online platforms

• Invoice finance. This works like a cash advance – the lender provides funds based on the value of an unpaid invoice minus a fee

• Overdrafts. Like a personal overdraft, a business overdraft is a facility that you can use if the balance of your business bank account hits zero

• Line of credit – much like a business credit card, a line of credit allows you to spend up to a set limit. You’re typically charged interest on whatever you use.

You can use a mix of debt financing options. For instance, you might have an overdraft for occasional unexpected bills and a five-year secured loan covering operating costs.

Using multiple forms of debt can be beneficial, but it's essential you don’t take on more debt than your business can afford to repay. High debt levels can quickly affect cash flow and lead to difficult situations that may threaten your business’s ability to operate.

Pros and cons of debt financing 

Debt financing can be a great option for small businesses, but it’s not without its fair share of risks. 

Let’s have a look at the pros and cons:

Pros

• Retained ownership. You don’t need to give up any equity when you take on debt, meaning you retain full control of your business, including any decision making.

• Predictable repayments. Most debts come with familiar and predictable repayment schedules. Whether it’s loans, credit cards or overdrafts, you either repay the debt plus interest in full or make monthly payments towards it. This helps you get a clearer view of monthly cash flow.

• Tax benefits. You can’t put all your debt repayments down as expenses on your tax return, but interest payments are usually tax deductible. This reduces your overall tax liability.

• Improve your business credit score. In the early days, it can be difficult to show lenders that your business can repay debt. Just like with a personal credit score, the more you borrow and repay on time, the more your business credit score will improve. Boosting your score helps you borrow larger amounts with more attractive interest rates in the future.  

Cons

• Repayments. There’s no getting away from the fact you need to repay debt. If you don’t stay on top of repayments, the amount owed can grow into a large sum, impacting monthly cash flow. This is especially true if you’re borrowing a lot.

• Interest. Every pound your business borrows tends to accrue interest. The rate may vary, but it still adds up. The longer you take to repay debt, the more interest accumulates, which can ultimately make borrowing an expensive option.

• Credit score risk. While making repayments in full and on time can do wonders for your credit score, missing payments has the opposite effect. If you continue to miss payments, you may find that you can't borrow at all. Lenders may also seize assets crucial to your operations.

• Increased financial risk. The more money you owe, the more strained your business might become. Remember that income goes up and down over time, so only borrow what you can afford to repay.

What is the difference between debt financing and equity financing?