Debt Financing vs. Equity Financing: What’s the Difference?

Entrepreneurs are faced with a plethora of big decisions when it comes to business financing, so much so that it can feel intimidating. One way to narrow down your options early on is to decide whether you want to use debt financing or equity financing.

Both debt financing and equity financing have their advantages and challenges. Your choice can significantly affect your company’s governance, risk profile, and long-term financial health. 

Given that 68% of small business owners believe access to financing is the most critical factor in their growth, there’s no doubt that the option you choose can dictate your company’s future success. Continue reading to ensure you take all of the differentiators between debt financing and equity financing into account before deciding which option best suits your business.

What Is Debt Financing?

With debt financing, you borrow and repay money from a lender over a set period, plus interest. The upside is that you retain complete control over the business with this approach, although you’re required to make regular payments for the life of the loan. Debt financing isn’t dependent on business performance, unlike equity financing, so you must pay off the debt regardless of how well your business performs.

This type of financing is often used to fund long-term investments or manage short-term cash flow needs without diluting ownership. Still, taking on large amounts of debt can be risky, particularly for new or small businesses.

Advantages of Debt Financing

Debt financing comes with plenty of upsides, including:

• Growth Opportunities: You can use the funds from your lender for just about anything, as long as it fits the loan terms. Debt financing is ideal if your company already expects high returns on this investment and has proven cash flow.
• Ownership Retention: Equity financing requires giving up a portion of the business to an investor. Debt financing allows you to retain full ownership of your business, preserving your original vision without sharing decision-making power.
• Potential Tax Benefits: This isn’t the case for all debt financing deals, but some allow you to write off interest payments on debt. These tax-deductible payments could help offset the sting of interest payments when your tax bill is due.
• Predictability: Debt financing comes with stringent requirements for paying off the loan. While these might seem daunting initially, they offer a great degree of predictability for financial planning. Try to get a loan with a fixed interest rate, which will make it easier to manage cash flow for long-term loans.

Disadvantages of Debt Financing

Debt financing allows you to retain ownership and sometimes has tax benefits, but it isn’t the right option for all companies. It has several downsides, including:

• Interest: The biggest downside of debt is accepting the cost of interest. While paying off the loan early can reduce the amount of interest paid, these costs can still become burdensome over time. Always calculate the total cost of interest over the life of the loan to understand just how much the loan will cost your business in the long term.
• Repayment Requirements: You must repay the debt regardless of how the business performs. If you take a risk by going into debt and it doesn’t pay off, you could hurt the business’s financial standing.
• Credit Risks: All debt comes with risk. High levels of debt can increase financial risk, affecting your business credit score and ability to get additional funding in the future.

Examples of Debt Financing

Debt financing comes in plenty of forms, allowing you to choose the option that best aligns with your vision for the company. Here are just a few examples of financing where you can retain equity:

• Term Loans: Traditional bank loans are popular for businesses with a proven credit history and track record. In this case, you borrow a lump sum and repay it to the bank, usually with monthly payments, including interest.
• Invoice Factoring: With invoice factoring, you send your unpaid customer invoices to a factoring company like altLINE. While you aren’t technically going into debt, you sell these invoices to the factoring company to receive upfront cash. The factoring company collects on the invoice, gives you a portion of the remainder, and retains a set percentage as their fee. This is a great option if you have existing clientele and only occasionally need funding.
• Lines of Credit: A revolving line of credit gives you a lot of flexibility. You qualify for the line of credit and then only borrow (and pay interest on) what you need.

What Is Equity Financing?

Equity financing involves selling shares in your company in exchange for capital. Unlike debt financing, you don’t have to repay the money or pay interest. Instead, investors partially own the business and share the profits with you.

While this means you have less of a say in the company’s direction, you avoid the risks of debt while accessing substantial capital.

Advantages of Equity Financing

Popularized by shows like Shark Tank, equity financing has a lot of advantages for small businesses and startups, including:

• No Need for Repayment: Unlike debt financing, equity financing doesn’t require monthly payments, which helps businesses preserve cash for growth. Plus, your business can improve its credit rating with less debt on the balance sheet.
• Risk Sharing: Investors share the financial risks of the business. If the business doesn’t perform well, there’s no obligation to repay investors.
• Long-Term Growth: You don’t have to agree to years of monthly payments with equity financing, allowing you to reinvest capital into the business. Plus, this option gives you access to expert investors with industry expertise.

Disadvantages of Equity Financing

Some small businesses believe equity financing is less risky than debt financing, but this approach has several disadvantages:

• Ownership Loss: The biggest downside of equity financing is that you have less control over the business, limiting your decision-making power.
• Profit Sharing: Investors expect a share of profits in exchange for their upfront investment. This approach can easily become more expensive than the interest you pay in debt financing, especially as the company grows.
• Complexity: Equity financing is famously complex. Raising capital is time-intensive and has a lot of requirements for compliance and disclosure. It could take months to get funding.

Examples of Equity Financing

There are several types of equity financing, such as:

• Angel Investors: These are high-net-worth people who provide a large lump sum of capital in exchange for equity in your business. Most angel investors want to invest in early-stage startups.
• Venture Capital: VCs are firms that invest in fast-growing startups. You get the benefit of a firm’s expertise, although they often have very strict requirements for how the business operates.
• Private Equity: Private equity firms prefer to work with more established, medium-sized businesses. They specialize in expansion and restructuring.

Debt Financing vs. Equity Financing: What’s the Difference?

Choosing between debt financing and equity financing is one of the most crucial decisions business owners make when seeking out capital. You can use the following table to help decide the best fit for your company.

How to Choose Between Debt and Equity Financing

So which option is better—debt financing vs. private equity?

The right choice depends on factors like your company’s growth stage, cash flow stability, and willingness to share ownership. Here are some key considerations to help you decide between debt or equity financing:

• Cash Flow: Debt financing is better if you have steady cash flow and can pay interest and monthly payments. Equity financing is better if you have irregular cash flow and are still growing. Not having monthly payments gives you more flexibility to reinvest in your company. Create cash flow projections to understand if you can handle debt repayment comfortably or if equity might be a safer option.
• Control and Ownership: Debt financing allows you to retain control over the business, so if you care about decision-making power or have a strong vision, debt financing might be the better choice. Equity financing involves giving up a portion of control to investors who want a say in the company’s direction, and the more you sell, the less control you retain over time. However, you benefit from sharing risk with investors and accessing helpful insights from these industry pros.
• Cost and Risk: Debt financing is generally less expensive because the interest payments are often tax-deductible. Plus, you’re done when you pay off the loan versus equity financing, where you’re on the hook for investor dividends long-term. However, debt increases financial risk due to fixed repayment obligations, while equity spreads the risk among investors without repayment pressure.

Debt vs. Equity Financing: In-Summary

There is no one-size-fits-all answer to which is better—debt financing vs. equity financing. The right choice depends on your business’s cash flow, growth stage, control preferences, and financial goals.

Debt financing is better for businesses with predictable cash flow that can comfortably support monthly payments, including interest. Debt financing comes with financial risk, but you retain ownership of your company. Equity financing, on the other hand, doesn’t require repayment but does mean you give up a percentage of control in your business. Raising additional capital with this option means you lose more and more of your business, so it may not be a fit if you want complete control of the company’s future.

The good news is that you don’t have to choose just one funding option. For many businesses, a balanced mix of debt and equity financing provides the best of both worlds, leveraging the tax benefits of debt while spreading risk with equity.

Debt vs. Equity Financing FAQs

Is it better to finance with debt or equity?

It depends. Debt financing might be better if you want to retain control of your business and benefit from tax-deductible interest payments.

It’s generally less expensive in the short term but increases financial risk because of mandatory repayments. Equity financing could be the right choice if you need substantial capital, don’t want to repay these funds, and are willing to share ownership. It reduces financial risk but can be more expensive in the long run because of profit sharing.

How do you calculate equity financing percentage?

Follow this formula for the equity financing percentage:

Total Equity / (Total Debt + Total Equity) x 100 = Equity Financing Percentage

For example, if your company has $500,000 in debt and $500,000 in equity, your percentages would be 50%.

Can a business have a mixture of both debt and equity financing?

Yes. A mixture of debt and equity financing allows businesses to benefit from the tax-deductible interest on debt while minimizing financial risk. This strategy also prevents ownership dilution by limiting the reliance on equity.