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Debt vs Equity Financing for Your Small Business
Debt and equity financing are both ways to get funds for a business:
- Debt is where the company borrows money from a lender and repays it over time with interest.
- Equity is where the company gets money from investors that become part owners of the company and get paid a share of future profits.
The biggest difference between debt and equity financing is ownership and risk. With debt, you maintain full ownership of your company, but you take all the risk if the investment fails. With equity, you’re selling a share of ownership and future profits, sharing the risk with the new part-owners.
Which choice is better depends on your needs and situation. Here’s a cheat sheet to help you compare debt vs. equity financing for situations that you’ll learn about in this article.
| Debt Financing | Equity Financing | |
| Keep all profits | Yes, after repaying the debt | No, share them with new owners |
| Full control of business decisions | Yes, if you don’t violate the terms of the debt contract | No, new owners have a vote |
| Must repay if investment fails | Yes, with interest | No, and new owners share in losses |
| Tax benefit | Yes, write off interest expense | No |
| Builds business credit score | Typically, with on-time payments | No |
| Collateral or personal guarantee required | Yes | No |
| Adds strategic skill sets to help growth | No | Yes |
| Good for long-term investments | Yes | Yes |
| Good for short-term needs | Yes | No |
| Requires revenue, cash flow, and financial history | Yes | No |
When Debt Is Better Than Equity Financing
Debt financing is better than equity financing for a business when you are:
- Making low-risk investments.
- Wanting to maintain full control of business decisions.
- Funding short-term investments.
Low-Risk Investments
Debt is better than equity financing when you are making low-risk investments, because you’ll be able to start making payments immediately, you will keep all future profits, and you might be able to write off interest expenses to lower your tax bill. Here are two examples of low-risk investments:
- Replacing machines or vehicles with business loans for equipment, where the new equipment increases productivity.
- Stocking up inventory for the busy season with inventory financing. The inventory works as collateral to keep interest rates low for the loan, and you can use existing cash flow to hire and train additional staff before the season starts.
Full Control of Business Decisions
Debt financing lets you keep control over business decisions without equity investors having a say. When investors are part-owners, they will want input on decisions because they get paid from profits. Even if they can’t outvote you on a decision, they can cause extra hassle and stress when they disagree. When you take debt financing over equity, you stay in control of the decisions and can keep decision-making processes shorter and less complicated.
Debt lenders, on the other hand, won’t get involved in the day to day or worry about the “why” behind your decisions if you make on-time payments. This doesn’t mean you will have 100% freedom though. You won’t be able to sell assets used as collateral for the loan without the lender’s approval, for example.
Short-term Investments
Debt financing is normally better than equity financing when you need money for short-term projects and expenses because the total interest cost on the loan will be much less than giving up a share of the company’s profits forever.
A short-term loan for working capital provides funds to hire seasonal staff, run ads for more customer demand, or rent additional square footage during busy seasons. Although interest rates will be higher than on long-term loans, the total cost of interest is usually less than that of long-term loans and is far less than giving up a share of profits indefinitely.
Getting approved for short-term debt will be faster than finding equity investors, making things like emergency loans far superior to equity financing when disaster strikes.
Times When Equity Financing Is a Better Choice Than Debt
Equity financing is a better option than debt financing when:
- You can’t get approved for a small business loan.
- Making high-risk or uncertain investments.
- Near-term cash flow is tight.
Denied for a Small Business Loan
Equity financing is better than debt when traditional and alternative lenders deny your application for a small business loan, especially in circumstances when you:
- Have a great idea but no established revenue.
- Don’t have a good business credit score or long enough financial history of stable and growing cash flow.
- Are lacking enough business collateral to secure the loan and can’t commit to a personal guarantee.
Equity investors will risk money on a good idea even if the company lacks revenue because they’re betting on profits down the line. Traditional lenders will pass because their income relies on your company having cash flow to make payments on time.
This is also why many small business lenders want two or three years of stable and growing cash flows, along with a good business credit score, before approving a loan.
The bonus of equity investors is that they bring skills from people within their network, and they can make introductions to large customers, new vendors, and suppliers to help with operations. Depending on the space your company operates in, equity investors may help you navigate different regulatory or political areas, too.
High-risk or Uncertain Investments
Equity financing is better than debt for high-risk or uncertain investments because investors share the risk with you. Keep in mind: There is no requirement to pay them back even if the investment doesn’t pan out.
Expanding into new locations or new product markets are examples of high-risk investments, and equity financing can provide a double benefit by offering you:
- The funding needed to grow.
- Strategic help like introducing you to new retailers or distributors in new markets.
- Insights on new regulatory environments or new consumers and product lines.
Debt lenders won’t approve loans for high-risk investments like these without substantial collateral or enough cash flow in your existing business to cover the amount of the loan if you default.
Tight Near-Term Cash Flow
Equity financing is better than debt financing when you have tight cash flow because you don’t need to give equity investors a penny until you turn a profit. With debt financing, you start repaying lenders immediately, and missing payments could put you into default, forcing you to sell off business assets.
Cash flow can be tight for expected reasons, like spending on R&D before getting a blockbuster product to market, or it can happen unexpectedly and out of your control in situations where:
- A big customer goes bankrupt without warning and without paying outstanding invoices. You must now wait for the long bankruptcy process before getting paid, if you get paid at all.
- Your community shuts down after a natural disaster.
- New unforeseen technology disrupts the entire market and steals customers.
If you don’t have enough cash flow buffer to make it through situations like these, it could be better to opt for equity financing.
Both debt and equity financing help your business grow, but which one is best depends on the situation. Debt financing is better when you want to keep all future profits, are making low-risk investments, or need short-term funds. Equity financing is better when you can’t get approved for a traditional business loan, you want to share the risk in uncertain investments, or you won’t have cash flow in the near term to safely make payments on a loan.
QuickBridge does not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only. You should consult with your own tax, legal, and accounting advisors.
