What is the difference between debt financing and equity financing?

What is equity financing?

When you own a business concept or company, there’s a subjective value attached to it called equity. The equity of any type of asset—whether intellectual or physical—is the value someone is willing to pay for it, minus its liabilities. That could mean the value of an entity today (measured in time and money invested) versus its value in the future (measured by comparable growth).

Once the owner and investor determine the “valuation” of the asset, the owner can then sell parts of the equity to raise capital. 

Types of equity financing.

There are a variety of methods to raise equity capital, including seed capital, angel capital, and managed venture capital. Here’s a closer look at each of these popular equity financing solutions. 

Seed capital

Seed capital typically comes from private investors (often personal sources like friends and family members) during the startup phase of a company’s development. It only qualifies as equity financing if the investor receives a piece of the company in return for its investment.

Angel capital

Angel capital comes from angel investors—typically high-wealth individuals who invest in businesses (startups included). In exchange for angel capital, an investor will require a piece of the companies in which they invest.

Managed venture capital.

Venture capital funds come from managed, pooled investments. This type of funding is usually only available to startups with the potential for rapid growth and high returns. Again, you’ll have to give up a share of your business in exchange for the investment dollars you receive. 

What is debt financing?

Debt financing is a source of business funding where a lender provides to the business an agreed-upon amount of money that is to be repaid over a period of time, in addition to any associated fees or interest.

Types of equity financing.

There are a variety of methods to raise equity capital, including seed capital, angel capital, and managed venture capital. Here’s a closer look at each of these popular equity financing solutions. 

Seed capital

Seed capital typically comes from private investors (often personal sources like friends and family members) during the startup phase of a company’s development. It only qualifies as equity financing if the investor receives a piece of the company in return for its investment.

Angel capital

Angel capital comes from angel investors—typically high-wealth individuals who invest in businesses (startups included). In exchange for angel capital, an investor will require a piece of the companies in which they invest.

Managed venture capital.

Venture capital funds come from managed, pooled investments. This type of funding is usually only available to startups with the potential for rapid growth and high returns. Again, you’ll have to give up a share of your business in exchange for the investment dollars you receive. 

Key differences between debt financing and equity financing

Understanding the key differences between debt financing and equity financing can help you make an informed decision tailored to your business needs.

1. Ownership and Control

• Debt Financing: You retain full ownership and control of your business. Lenders have no say in business decisions.
• Equity Financing: You give up a portion of ownership in your business. Investors may have input on business decisions and strategic direction.

2. Repayment Obligation

• Debt Financing: Requires repayment of the borrowed amount, plus interest and fees, according to the lender’s terms.
• Equity Financing: No obligation to repay the investment. Investors expect returns in the form of dividends or an increase in the company’s value.

3. Profit Sharing

• Debt Financing: Profits remain with the business owner. There is no requirement to share profits with lenders.
• Equity Financing: Profits need to be shared with investors based on their equity stake. This can reduce the total profit that goes back to the business.

4. Credit Impact

• Debt Financing: Can help build business credit if the lender reports to credit agencies. Poor credit might make it difficult to qualify.
• Equity Financing: Doesn’t impact business credit directly. Credit history is generally not a barrier to obtaining funds.

5. Business Risk

• Debt Financing: Poses a risk if the business is unable to meet repayment obligations, potentially leading to loss of collateral or personal assets if a personal guarantee is involved.
• Equity Financing: Reduces financial risk since there’s no debt to repay, but you risk losing a measure of control and having to share future profits.

Considering these differences can clarify which financing option aligns best with your business goals and current financial situation.

When to choose equity vs. debt financing.

Every business has to choose for itself whether equity financing or debt financing makes the most sense, and many companies opt for a mixture of both types of funding. There are risks with either option you choose. 

If your business closes and it still owes outstanding debts, you may still have to repay those loans plus interest. The same isn’t true with equity financing. On the other hand, if you sell your business for a sizable profit, paying off shareholders could be much more expensive than the cost of paying off a business loan. 

It’s up to you to weigh the pros and cons of each type of financing and figure out which solutions make the most sense for your business. 

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_{Information provided on this blog is for educational purposes only, and is not intended to be business, legal, tax, or accounting advice. The views and opinions expressed in this blog are those of the authors and do not necessarily reflect the official policy or position of Lendio. While Lendio strives to keep its content up-to-date, it is only accurate as of the date posted. Offers or trends may expire, or may no longer be relevant.}