Debt vs Equity Financing
Advantages and disadvantages
Business activities and investments are financed by raising funds through owners’ equity, debt financing, or a combination of the two. Most businesses start with the owners financing the business using their own personal equity funds. When further finance is required for business expansion, the decision for small business owners is whether to apply for a bank loan or look for an investor?
Equity financing involves having investors invest in the business. The new investors could become partners in a partnership, or shareholders in the company operating the business. The advantage of equity financing is that it is less risky than a loan because the investment does not have to be paid back even if the business fails. In addition, as there are no interest and loan repayments the business has more cash for expanding the business.
The disadvantage of equity financing is that the new investor(s) have ownership of part of the business and will share in the profits. Investors will also need to be consulted before making major (or even routine) decisions.
Debt financing involves having a bank provide loans to finance the business. The advantage of debt financing is that the bank does not have any ownership of the business and the interest on the loan is tax deductible. There is flexibility as loans can be short term or long term and the loan repayments are known and can be budgeted for.
The big problem with debt financing occurs when businesses rely too much on debt and have cash flow problems. Difficulties in paying the loan back may mean the business closes. In addition, most small business loans require the owners to personally guarantee repayment of the loan so their personal assets are at risk if the loan cannot be repaid in full.