Debt vs. Equity Financing: Which One Is Right for You?

rowing a small business can be tricky, even if you have an innovative product and a surefire business plan. One of the biggest obstacles you'll face is raising money as a small business, since you may not have the revenue, capital, or assets to fund your operations yet. Debt and equity financing can be viable options to scale a small business, but you should carefully consider your choice.

‍

What is debt financing?

Debt financing refers to what probably comes to your mind when you think of business credit. It includes different types of business loans and business lines of credit.

Debt financing works similarly to personal business loans: You borrow a certain amount and agree to pay it back in monthly installments. This includes a finance charge, commonly known as the interest rate or annual percentage rate (APR). Over the term of the loan, you'll be paying back the initial amount plus the interest that accrues.

‍

Benefits of debt financing

Debt financing can be a great way to grow your business as it offers flexibility to help you invest your money where you see fit. These are some of the top benefits of debt financing for small businesses.

No need to give up control of the business

One of the biggest benefits of getting a loan is that you can decide what to do with the money. As a small-business owner, nobody understands your business as well as you do. That’s why getting a loan is a popular way to fuel growth in the initial stages since you don’t have to run your decisions by stakeholders or investors.

Interest is tax-deductible

In general, any interest you pay on your business loans is tax-deductible. This means you may be able to write off most or all of the costs associated with debt financing, making it a low-cost way of obtaining funding.

However, whether your interest is tax-deductible depends on the type of loan you obtain and what you use the funds for. If you’re not an expert in filing taxes for your small business, then it’s best to consult an accountant or a tax professional to determine whether your loan interest is tax-deductible.

Payments do not fluctuate

You'll receive a contract with all of the terms and conditions when you're approved for a loan, including the repayment schedule, your APR, and any additional fees. This will give you a solid idea of what your monthly payments will be like for the duration of the loan, which can help you plan ahead.

‍

Downsides of debt financing

Debt financing isn’t always the way to go for small businesses. Here are some of the biggest downsides.

Qualifying for a loan may be difficult

Lenders will look at your business’s income statements, balance sheets, cash flow statements, and other financial documents to assess your ability to repay the loan. This makes it difficult for new businesses and those struggling with cash flow problems to get approved for such financing. In fact, less than half of all small businesses in the U.S. think that their credit needs are being met.

Payments start right away

Generally, loans require businesses to start making payments within 30 to 45 days after receiving a new loan. This means you may not have enough time to generate a return on your investment before you're required to make payments on your loan.

Puts assets at risk

Defaulting on a business loan can put your business at risk, especially if you obtained a secured business loan. For example, you may be able to obtain a loan if you put up your delivery truck as collateral. However, this means the lender may be able to repossess the truck if you stop making payments.

‍

What is equity financing?

Equity financing involves selling a percentage of your company to raise capital. With equity financing, an investor will pay you a sum of money in exchange for shares in your company, or a percentage of ownership.

For example, let’s say you want to raise $10,000 through equity financing. In that case, you would have to look for an investor willing to pay $10,000 for a portion of your company. You would then negotiate with the investor to find a percentage of your company that is appropriate for the amount of money you're asking for.

‍

Benefits of equity financing

Equity financing offers several benefits, especially for companies looking to scale quickly. Here are some of the top benefits.

No repayment obligations

Unlike debt financing, equity financing doesn’t need to be repaid. This can be especially helpful for new businesses that are looking to reinvest as much money as possible into their growth, as they won’t be saddled with debt.

Easier to qualify for startups

Loan providers will look at financial statements to assess a company’s ability to repay a loan when deciding whether to extend credit. Investors, however, will look at a company’s product, business plan, and growth strategy when deciding whether to invest in the business. This means it’s easier to obtain equity financing for startups with a limited financial track record but a solid growth plan.

Partner with an experienced mentor

Finding an investor is a more intimate experience than finding a lender. While a lender is simply interested in your company’s ability to repay the funds, an investor will be interested in seeing your business succeed. This means partnering with the right investor can open the door to new suppliers and larger networks that can help you grow your business even faster.

‍

Downsides of equity financing

Equity financing isn’t the right choice for all businesses. Here are some of the most common downsides.

You give up a part of the business

Obtaining equity financing means you're giving up a portion of your business. While this financing can help you grow the business during a critical period, it also means you might miss out on a lot of value if your business succeeds.

For example, let’s say you sell 10% of your business for $10,000. After one year, you’ve managed to grow the value of your business to $200,000. This means the 10% share you sold for $10,000 is now worth $20,000, so you’ve lost out on $10,000 of added value.

That's why it's important to know what the difference is between debt financing and equity financing. In the example above, you may have been able to obtain a $10,000 loan with a 10% APR. If you were to repay the loan in three years, then you'd be paying a total of $1,616.19 in interest, which is significantly lower than the $10,000 loss of value in the equity financing scenario.

More time-consuming

Finding investors can be time-consuming, even for the most brilliant entrepreneurs. Even when you do find investors who are willing to take a chance on your business, the negotiation process can take weeks or even months. This means you won’t be able to get your financing immediately, whereas business loans are often approved within the same day.

‍

Which option will work best for my small business?

Deciding between debt vs. equity financing depends on the circumstances of your business. In general, small businesses with a solid financial track record can benefit the most from debt financing, while small businesses with a promising growth strategy can do better with equity financing.

Novo Funding is another excellent option for small businesses looking for funding. Apply today to see if you qualify for financing of up to $75,000.

Novo Platform Inc. strives to provide accurate information but cannot guarantee that this content is correct, complete, or up-to-date. This page is for informational purposes only and is not financial or legal advice nor an endorsement of any third-party products or services. All products and services are presented without warranty. Novo Platform Inc. does not provide any financial or legal advice, and you should consult your own financial, legal, or tax advisors.

The Merchant Cash Advance is provided by Novo Funding LLC, PO Box 311092, Miami, FL 33231. Novo is the marketing name for Novo Platform Inc. and its subsidiaries and affiliates. Novo Funding LLC is a wholly owned subsidiary of Novo Platform Inc. Credit and Merchant Cash Advance products and services are offered by Novo Funding LLC. The information and materials contained on this website - and the terms and conditions of the access to and use of such information and materials - are subject to change without notice. Not all products and services are available in all geographic areas. Your eligibility for particular products and services is subject to final Novo determination and acceptance.

Novo is a fintech, not a bank. Banking services provided by Middlesex Federal Savings, F.A.: Member FDIC.

‍