Starting a business is more convenient than ever, but every entrepreneur needs capital to start it, even if they only need a laptop and an internet connection. You can save and invest your own money, but to really grow or to start a capital-intensive business, you need debt and/or equity financing.
In this article, we explain two common ways to raise capital for your business: borrowing money (debt financing) and finding investors (equity financing). This post then explains what each method entails and in what ways one is better than the other.
What is debt financing?
Financing by debt means you’re borrowing money from a person(s) or organization(s). Terms can vary, but you generally pay back the principal (the original amount borrowed) after a certain time plus interest (compensation for the service of lending you money).
There are many ways to find debt financing. New businesses can ask friends and family for a loan, a bank can provide a loan depending on your credit score and business plan (among other factors), and there are also organizations who loan money to small businesses.
Once you’ve found someone to borrow from, you want to understand the terms of the deal. This includes the interest rate, when you need to pay back the loan, how frequent interest and principal payments are, and much more.
The lender may also ask for collateral—something that they can seize if you can’t return the money. If you’re borrowing to buy equipment, you can secure the equipment as collateral. But sometimes, the lender may ask you to collateralize personal assets such as your house.
Additionally, a co-signer requirement is a common criterion for a loan, especially if your credit score isn’t pristine. A co-signer is someone who’s responsible for paying back the loan in case you default. This is a big responsibility and often only a significant other or family member is willing to do it.
What is equity financing?
Equity financing is when you sell part of your company in exchange for cash. You refer to the buyer as an investor, and their status entitles them to the company’s profits in the form of a dividend. The investor(s) could also have voting rights, which gives them the ability to vote for or against changes in the business.
Finding someone to sell equity to is similar to finding someone to borrow money from. You can ask friends or family, but banks likely won’t have an interest in buying equity. There are firms that function for the sole purpose of investing in small businesses. These firms usually look for a large return and invest in high growth industries such as technology and cannabis.
Equity financing is a bit more complex than debt financing. An investor wants to see financial statements, a business plan, and much more. However, you only need to satisfy a lender with collateral or a co-signer.
Comparing the benefits of debt and equity
The most common reason to choose debt over equity is to keep control over your business. If you sell equity, you no longer control 100% of the business and have to run decisions by other shareholders. If you go as far as to sell the majority shares (51%+), these majority shareholders could even oust you from your own company! And while no one likes to pay interest, interest payments are tax deductible, meaning less of your business’ revenue goes to the Canadian Revenue Agency.
On the other hand, people frequently seek out investors so that the business won’t have to deal with interest and principal payments. Loosening the debt burden keeps your cash flow positive. Choosing equity financing also means you’re not on the hook in case the business can’t pay back the loan.
It’s usually a luxury to get to choose between debt and equity financing. But if the choice is there, your situation determines which way to go. If you’ve already taken on a lot of debt, it may be better to sell equity. The vice versa also applies. Also consider the interest rate—in that, if you can get a low interest rate, it could be better than selling equity.
Debt or equity? That is the question. There’s no right answer to it. But if you’re looking to grow your business or to start one and you need financial capital to do it, it’s a decision you have to make.
Related: What to look for in an investor