Debt vs equity: Advantages and disadvantages

You may find your business cannot operate on sales revenue alone, and you need to find a source of additional income. In these instances, you might seek out someone to loan or invest money into your business. There are two primary options these individuals can use to finance your company: debt financing and equity financing.

There are distinct advantages and disadvantages to each option, and this article will discuss them in detail. We’ll look at a variety of topics, including: 

• Debt vs equity
• Advantages of debt financing
• Disadvantages of debt financing
• Advantages of equity financing
• Disadvantages of equity financing

Debt financing is what most people would understand to be a loan. You borrow money from an individual, a bank, or some other institution, and then you need to repay the loan over a set period. Debt financing typically has an interest rate attached, which means that your debt will increase over time, so you’ll need to pay back more than you borrowed.

Equity financing is another way of getting funding for your business idea. With equity financing, a person or organisation essentially buys a portion of your business. You receive money in exchange for this portion, but the buyer now shares control over your business decisions. As they are a part-owner, they can change and influence the business.

The key advantage of debt financing is that you don’t need to give up any control over your company. Many small business owners are passionate about how they want to run their business, and they would not have the freedom to make their own decisions if they agree to equity financing.

With debt financing, things are much simpler. You borrow an amount of money and have to repay that amount, but the person loaning the money doesn’t receive any control over the business. The only thing they ask in return is the additional interest on the loan.

Another reason debt financing is simpler is because the transaction does not continue beyond repayment. Once you pay off the debt, your liability – which is your responsibility for repaying the debt – ends. 

This means that debt financing can save a lot of time, money, and hassle than more complicated funding ideas like debt financing. You can even return to the same institution again and again for further debt financing.

A big issue with debt financing is that it rarely accounts for your business circumstances. You must make consistent repayments for your debt at the agreed time and or the agreed amount. The disadvantage is that you have to do this whether your business is doing well or not. 

If you don’t have a plan for how you’re going to manage your debt, and your business is undergoing financial problems, having to make your repayments could cause serious issues.

Another issue with debt financing is that it can be unpredictable, specifically regarding interest rates. Economic factors like inflation can cause interest rates to rise, sometimes dramatically. Higher interest rates lead to higher repayments, which can create problems if you cannot repay the higher fees. 

If you have a great business idea and find the right investor, you can potentially get much more money from equity financing than you could with debt financing. Debt financing has a limit, depending on your credit and how much you’re able to repay, but equity financing is limited only by how much your investor is willing to give you.

A really interested investor might give enough money to not only launch your business but to fund years of operation and even additional product development. All they’ll need in return is partial ownership.

Equity finance can potentially be a great way of expanding your network. For example, your investors may have considerable industry experience or access to a huge group of useful contacts. If you agree to an equity finance agreement with the investor, you’ll also have access to these contacts, which can create all kinds of opportunities.

The problem many business owners have with equity financing is that they lose total control over the business. By agreeing to equity financing and part ownership, you may have to compromise on some decisions or agree to changes you wouldn’t make if you had total control. If you have a very specific idea of what you want your business to be, equity financing may not be the right choice for you.

Equity financing can be difficult to acquire without the right contacts and a great sales pitch for your company. As well as finding someone who will agree to provide equity financing, you need to iron out the exact terms of the agreement, which can take a lot of time. 

All the time spent arranging for equity finance is time you’re not using to run your business. As time is a hugely valuable resource for small business owners, think carefully before you devote too many hours to finding a good source of equity finance.

If you manage your finances carefully enough, you may find you never actually need to use debt or equity financing. This kind of careful financial management is difficult but much easier to achieve if you use tools like the Countingup app. 

Countingup is the business current account with built-in accounting software that allows you to manage all your financial data in one place. With features like automatic expense categorisation, invoicing on the go, receipt capture tools, tax estimates, and cash flow insights, you can confidently keep on top of your business finances wherever you are. 

You can also share your bookkeeping with your accountant instantly without worrying about duplication errors, data lags or inaccuracies. Seamless, simple, and straightforward! 

Find out more here.