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Debt vs. Equity Financing: Which Is the Best Way for Your Business to Access Capital?

The debt vs. equity financing quandary can loom large in small business owners' minds when they need capital to expand a business. Do you go to a bank and apply for a business loan? Or do you look for an investor? There are advantages and disadvantages to both. Here are the pros and cons of each to help you decide which money-raising choice is best for your business:

Equity financing

Having an investor come along and write you a check may seem like the perfect answer if you want to expand your business but don't want to take on debt. After all, it is money without the hassle of repayment or interest. But the dollars come with strings attached: You must share the profits with the venture capitalist or angel investor.

Advantages to equity financing:

  • Less risky than a loan because you will not have to pay it back, and a good option if you can't afford to take on debt.
  • You tap into the investor's network which may add more credibility to your business.
  • Investors take the long view and most don't expect a return on their investment immediately.
  • You won't have to channel profits into paying off a loan.
  • More cash on hand for expanding the business.
  • No requirement to pay back the investment if the business fails.

Disadvantages to equity financing:

  • May require returns that could be in excess of the rate you would pay for a bank loan.
  • Investor will require some ownership of company and a percentage of the profits.  You may not want to give up this kind of control.
  • You will have to consult with investors before making big (or even routine) decisions -- and you may disagree with your investors.
  • In the case of irreconcilable disagreements with investors you may need to cash in your portion of the business and allow the investors to run the company without you. 
  • It takes time and effort to find the right investor for your company.

Debt financing

The business relationship with a bank that loans you money is vastly different than an investor -- and requires no need to give up a part of your company. But you still need to give serious thought to the advantages and disadvantages of taking on too much debt -- a move that can stifle growth. 

Advantages to debt financing:

  • The bank or lending institution (such as the Small Business Administration) has no say in the way you run your company nor has any ownership in your business.
  • The business relationship ends once the money is paid back.
  • The interest on the loan is tax deductible.
  • Loans can be short term or long term.
  • Principal and interest are known figures you can plan in a budget (provided that you don't take a variable rate loan).

Disadvantages to debt financing:

  • Money must paid back within a fixed amount of time. 
  • If you rely too much on debt and have cash flow problems you will have trouble paying the loan back.
  • If you carry too much debt you will be seen as "high risk" by potential investors – which will limit your ability to raise capital by equity financing in the future.
  • Debt financing can leave the business vulnerable during hard times when sales take a dip.
  • Debt can make it difficult for a business to grow because of the high cost of repaying the loan.
  • Assets of the business can be held as collateral to the lender; or the owner of the company is often required to personally guarantee repayment of the loan.

Most businesses opt for a blend of both equity and debt financing to meet their needs when expanding a business; mixing the two forms of financing can complement each other and can reduce the downsides of each of them. The right ratio will vary according to your type of business, cash flow, profits, and the amount of money you need to expand your business.