Equity Financing vs. Debt Financing

Debt financing means a business borrows money it must repay with interest. This is a type of non-dilutive funding — the key difference between debt and equity financing — and means you don’t dilute ownership percentages with this type of funding. Debt financing is a common method of obtaining necessary capital for both small businesses and startups.

Equity financing means to raise capital for a business by exchanging an ownership percentage or "equity" in the company. Unlike debt financing, equity funding doesn’t include repayment terms. Instead, investors get repaid through their share of profits in the company. Equity financing investors often take a board seat on the company's board of directors and play an active role in the company's vision and decision-making.

If you choose equity financing for your startup, you'll need to find the right equity investors for your business. While these investors are commonly venture capitalists or angel investors, you can raise equity funding in a few other ways as well.

• Venture Capital (VC) — VC funding involves taking on large amounts of capital from venture capital firms or individual venture capitalists in exchange for a notable percentage of your company. This investment type is more common for startups than for small businesses.
• Angel Investors — Angel investors are typically wealthy individuals who make higher-risk investments in startups during the early stages.
• Equity Crowdfunding — Equity crowdfunding involves collecting investments from several individual investors (typically through crowdfunding platforms) in exchange for a small equity percentage.
• Corporate Investors — Companies often will invest through their corporate venture capital (CVC) funds or initiatives, and these corporate investors usually invest in later-stage and growth-stage companies.

If you choose debt financing to fund your venture, you can borrow money for your business in several ways (e.g., through a bank loan, credit cards, or merchant cash advances). Each type of debt financing will benefit different startups and small businesses at various stages. Here are the most common types of debt financing:

• Small Business Loan — Banks and other lenders typically offer business loans that require business owners to pay interest rates on the capital they borrow.
• Business Lines of Credit — A business line of credit involves borrowing capital up to a certain credit limit, but only paying interest on the amount of money the company actually borrows. Lines of credit often provide higher amounts of capital with lower interest rates than credit cards.
• Business Credit Cards — Corporate credit cards and lines of credit operate similarly. However, you can use business credit cards in-person and online with greater flexibility than a line of credit, and they often come with rewards and incentives for spending.
• Venture Debt — Reserved for venture-backed startups, venture debt is a loan used to support a startup's growth or operations — typically between series funding rounds.

Anytime you raise money for a business venture, the method you choose will have both advantages and disadvantages. Equity financing is no exception. From access to capital to ownership sacrifices, understanding these pros and cons can help you determine if this type of funding is right for your business.

• Access to a Large Amount of Capital — Most equity financing sources, such as angel investors and venture capitalists, are ready to invest large amounts of capital into their portfolio companies. This can help startups scale quickly.
• No Required Repayment — Because equity financing involves trading capital for company ownership, you don’t have to repay the money you borrow. This also means no debt.
• Other Investor Benefits — In addition to providing business capital, investors can help their portfolio companies in several other ways like offering mentoring and network-building opportunities.

• Less Control Over Your Business — Equity investors — especially the lead investor — will likely take a spot on your company's board of directors and be involved in the decision-making and strategy for your business.
• You Sacrifice Ownership — Because equity financing involves capital in exchange for equity, you sacrifice some ownership of your company and its profits.
• No Tax Incentives — Unlike debt financing repayments, with equity financing, distributing dividends to shareholders isn't a tax-deductible expense.

Debt financing also involves its own set of pros and cons, such as maintaining ownership and expense concerns. Below, you’ll find the key advantages and disadvantages of debt financing you should consider before diving into this funding method.

• Maintain Ownership — Unlike equity financing, debt financing doesn't require you to give up any ownership. This means you’ll have complete control over your business and its profits.
• Increased Cash Flow — Debt financing can put necessary capital in your pocket to grow your business instead of relying solely on revenue. Plus, you have the potential to turn a small amount of capital into rapid growth for your business.
• Tax Incentives — In general, interest payments on debt financing are tax deductible.

• Challenging Qualifications — Qualifying for a business loan isn't always easy for all business owners. Your personal credit score and time in business can impact your ability to secure debt financing.
• Interest Rates — In addition to repaying the money you borrow, debt financing options like business loans often involve paying interest on top of the loan amount.
• Weekly or Monthly Payments — Debt financing requires you to repay the amount borrowed, which means an additional weekly or monthly expense based on the repayment terms. This also means you must repay the borrowed amount even if your company fails or isn't generating revenue.

Unfortunately, there’s no one-size-fits-all answer to whether debt or equity financing is a better option. Every business is different and, therefore, will have individual funding needs and qualifications. However, equity financing is a strong option for startups aiming to rapidly scale their business as well as the most common for growth-oriented businesses.

Alternatively, debt financing will likely suit small businesses or companies looking for a small amount of money to support their business because it’ll allow the business owner to retain control of their company.