Very few businesses get from the startup phase to full maturity without taking on debt. It costs money to run a business. And of course, you have to spend money to make it. This reality leaves business owners with a number of options for addressing financing needs. Two of the options are debt and equity financing. Not only are they not the same thing, but they are also not even similar.
Right off the bat, there are drastic differences between debt and equity. Debt is something you owe; equity is something you own. Think of it in terms of a mortgage. Any outstanding balance on your mortgage is debt you owe to your lender. If you owe less than your home is worth, the difference is your equity. You own it because you own the home.
Companies looking for financing solutions may face having to choose between debt and equity financing. A good case can be made for both. However, because no company can be absolutely sure of future earnings, borrowing is a risk regardless of the chosen option.
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Debt Financing Explained
The best way to understand debt financing is to think of small business loans. A company is looking for a $50,000 loan to upgrade equipment and expand its physical space. By taking on a loan, the company is assuming a total debt that includes the original $50,000 plus interest and associated fees.
A telltale sign of debt financing is a regular repayment schedule. In our fictional scenario, the business owner might make monthly payments for a period of five years. Those monthly payments constitute a known and fixed expense. Not generating enough revenue to cover the payments could leave the company in financial straits.
Another less common form of debt financing is hard money. Hard money loans are provided by private lenders, like Salt Lake City’s Actium Partners. A typical hard money loan is offered for a term of between one and three years. Some loans are structured with monthly payments while others are interest-only loans with a balloon payment at the end of the term.
Equity Financing Explained
Equity financing is a means of securing funding through private investment. In some cases, business owners go to private equity firms that specialize in this sort of thing. Other times, funds are raised by enlisting the support of family members, friends, etc.
The distinguishing characteristic of equity financing is that the business owner gives the investor a share of company ownership. Let’s say an owner decides to raise $50,000 via equity financing rather than getting a small business loan. Let us also say he finds an investor willing to loan the money in exchange for 25% share of ownership.
Rather than making monthly payments, the business owner pays the investor 25% of his profits over the life of the agreement. It is quite possible he could end up paying more than $50,000 in total. On the other hand, he could pay significantly less if his business doesn’t generate enough revenue.
The big downside to equity financing is giving up some measure of control. Every person or organization that owns a share in the business has at least some say in how it is run.
Both Options Work
At the end of the day, both options work as funding tools. Debt financing provides the necessary cash in exchange for interest payments. Equity financing provides the cash in exchange for an ownership share. Business owners pay for the privilege of borrowing either way. So really, it is about counting the cost. The best choice is usually the one that ends up costing less.