November 06, 2022 •
Business owners are always required to have strong financial acumen and knowledge because a lot depends on their ability to infuse capital efficiently into their venture. However, it’s not always an easy decision to make and requires lots of research to figure out the best option for financing various business requirements and operations.
Small business owners are usually more risk-averse in terms of finances and investment. This is mostly due to the reason that any miscalculated step can affect the growth of their business when they most need it. While being careful with finance-related decision-making is crucial for any business owner, there are several funding options available that can help them transform their business in the best possible way. In this blog, we’ll discuss two such business financing modes – Debt financing and Equity financing.
To know which works best for small businesses, it is important to know the key differences between Debt and Equity financing. Let’s explore them!
Difference between Equity Financing and Debt Financing
Here are the top differences between debt and equity financing:
Meaning & Definition
- Debt Financing - Debt financing refers to any kind of financial assistance that involves borrowing a certain sum of money from a lender and paying it back at pre-determined interest rates. It is an excellent way to secure additional funds for your business without having to put up any collateral. One excellent example of debt financing is a Business Loan for MSME.
- Equity Financing - Equity financing is a form of financial support for businesses that involve selling a certain percentage of your company’s stake to an investor or investors who stand to benefit from any profits incurred by your business in the future. One prime example of equity financing is in the form of Angel Investors.
Debt Financing - Debt financing can be of the following types:
- Term loans: Term loans are typical loans offered by banks and financial institutions that provide an upfront lump sum to borrowers under specific terms of repayment over a period.
- Business Loan for MSME: These loans are specifically designed to provide financial assistance to Micro, Small, and Medium Enterprises (MSMEs) to fulfil their business goals at specified terms as laid down by their lender.
- Business Line of Credit: A Business line of credit is another form of business loan that can be borrowed by small business owners on an as-needed basis. It is a revolving credit that can be used to fulfil short-term funding or financing business requirements.
- Credit Cards: Business credit cards are another good option to finance short-term finance requirements which can be paid back within a specified time. It helps in improving your credit score.
Equity Financing - Sources of Equity financing include:
- Crowdfunding: Equity crowdfunding is a form of fundraising from various sources like angel investors, business-related crowdsourcing platforms, and venture capital firms. It may also include Initial Public Offering (IPO).
- Angel Investor: An angel investor is a person who provides funding or capital to a business or start-up in exchange for a share in the business. They also provide operational as well as technical expertise and advice to help improve the business.
- Mezzanine Financing: Mezzanine financing is a hybrid mix of both debt and equity financing. It allows lenders to convert any debt owed to them by a business into an equity share or interest in the company in case the business owner defaults on repayment.
- Venture Capitalists/Capital Firms: Venture capital is a type of private equity that is provided by investors to small businesses and start-ups that show promise and a positive return on investment.
Duration of Financing
Duration of financing refers to the specified period of repayment or tenure of the finance provided to small businesses.
- Debt Financing - Debt financing is relatively short-term as it is limited by the duration of repayment, i.e., loan tenure. Short-term debt financing can be used for emergencies with a payback period of one year. Long-term debt financing could be up to 3 years or more depending on your lender.
- Equity Financing - Equity financing doesn’t have a fixed tenure or repayment duration. While it is a form of long-term financial assistance, it does not have any date of maturity. Instead, investors receive dividends when the business makes profits.
Also Read: How Technology Is Helping To Get Personal Loan Digitally
Debt Finance Vs Equity Finance: Which One is Best for Small Businesses?
To find out which option works best for small businesses, here are some pros and cons of debt and equity financing that you should know.
- Clearly defined terms
- No external involvement in business operations
- Interest payments are tax-deductible
- Repayment and interest costs vary
- Possibility of missed payments leading to loss
- Scheduled payments must be on time
- An excellent option for start-ups
- Enables rapid business growth
- No requirement for repayments until the company becomes profitable
- Not an easy financing source to obtain
- The investor has some control over business operations
- Some loss in financial or strategic control
Now that you are equipped with relevant information on the difference between equity financing and debt financing, it should give you a fair idea of which option to choose for your small business. Remember to always do your research on the market and industry in which your business operates, figure out the latest best practices used by your peers as well as the competition, and go with the one that best suits your requirements.