What Is Equity Financing? Debt vs. Equity Financing

Susan GuilloryUpdated June 6, 2021

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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.

For startups in search of capital to help them launch or grow, equity financing is a common solution, but it’s not the only one. Some businesses prefer to take out a loan rather than give up equity to investors. But others appreciate the fact that equity financing doesn’t have to be paid back the way debt does.There are pros and cons to both equity financing and debt financing. Review the highlights of each carefully to make your decision about what’s best for your startup.

Debt vs. Equity Financing: How to Choose the Right Option for Your Business

It takes money to start a business, and it takes more money to sustain or even grow it. You may have enough in your bank account to cover these costs for your startup, but many business owners don’t. Startups are, by their nature, young. So many don’t meet the qualifications for time in business or credit history required by traditional debt financing through a bank. Others that do qualify for loans may not receive as much money as they need. In fact, in the Federal Reserve's 2019 Small Business Credit Survey, 54% of small employer firms that applied for $250,000 or less in loans didn’t receive the full amount.These startups have another option: equity financing. Because equity financing has no requirements for how long a startup must have been in business to qualify, it may provide the capital your startup needs without saddling you with debt. Still, there’s no such thing as free money, so it’s a good idea to make sure you understand both the costs and the benefits. Recommended: 13 Ways to Fund a Startup

What Is Equity Financing?

Equity financing (also called equity funding) describes what happens when an individual or company invests in a startup in exchange for a percent of ownership of that company. The funds don’t have to be repaid, but the investor, who now has equity in the company, may have voting rights or other influence on how the business is run.Equity financing can occur through a startup working with a venture capital firm or angel investor, or through an initial public offering (IPO).

Benefits of Equity Financing

The big benefit is money you don’t have to pay back. What’s not to love about that? But equity finance offers many perks that may appeal to startups.

It Opens the Door to the Capital You Need

If you’re having difficulty finding debt financing that you qualify for (especially at a low interest rate), you may be ready to give up on your search. But equity financing was designed with startups in mind. It may give you the capital you need — investors often provide more funds than a bank would loan you—and start making plans for your company’s growth.

It Gets You Access to Industry Experts

Investors tend to invest in industries they know well. That’s a potential boon for you because it can provide you access to experts who can give you valuable advice and make introductions to potential partners or customers in your field.

The Funds Don’t Have to Be Paid Back

Best of all, you don’t have to pay back the funds, at least not immediately. At some point, you will need to pay your investors their equity. Often, this happens when a startup is acquired or when the business is thriving, since an investor’s shares will be more valuable then.

Drawbacks to Equity Financing

Though equity financing could be the solution to getting the capital you need, there are a few potential challenges to consider.

You Lose Some Ownership (and Profit)

With debt financing, you retain full ownership of your startup, and once you pay back your loan, you can keep all the profit your company makes. But when you take on investors, you share that profit, which may mean less money in your own pocket.

You’re Not the Only Decision Maker

While in theory, having investors who are experienced in your industry and who have contacts could be a good thing, it does add more voices and opinions to the mix. Instead of you (and maybe a cofounder) making all the decisions alone, you may now need to take your investors’ opinions into consideration.

It’s Slow

Unlike taking out a small business loan (if you qualify), acquiring equity financing can require some time to complete. First comes the often difficult process of organizing your financials and creating a deck to appeal to the right investor. Then, if you do get a bite, you’ll have to negotiate terms.

Examples of Equity Financing

There are several types of equity financing you can consider for your startup.

There are actually two ways you can use shares to raise capital for your startup. You can sell shares to private investors, who then hold a percentage of your business’ equity. Or you can make shares available to the public through an Initial Public Offering (IPO) and your stock will be available on public stock exchanges.

Venture Capital

A venture capital (VC) firm or individual may invest money in a company with the intent of helping it grow to profitability with the VC’s resources and expertise. At that point, the firm or individual investor may cash out by selling shares.

Angel Investment

An angel investor (which can be an individual or a company) is similar to a venture capitalist with one exception: He or she will use his or her own money to invest in the startup. Many angel investors look to invest in early-stage startups.

Convertible Debt

Another example of equity financing is convertible debt. In this hybrid of debt and equity financing, a startup is given a loan. If it then meets certain performance goals, the unpaid balance can convert to an equity stake in the company. If those benchmarks aren’t made, the startup must repay the loan.

What Is Debt Financing?

Debt financing, in contrast to equity financing, is a loan or line of credit that a startup must pay back. The business agrees to make monthly payments, including interest, to a financial institution or lender.

Benefits of Debt Financing

When you’re looking for startup funding, debt financing has some major perks worth considering.

You Retain Full Ownership (and Profit)

Unlike equity financing, taking out a loan still allows you to retain full ownership of your business and full access to the profits it generates. That means you don't need to consult with investors when making decisions about your startup.

There May Be Tax Advantages

The interest you pay on debt financing is tax-deductible, which may lower what you have to pay on your business taxes.

It’s Fast

If you do qualify for a loan or line of credit, you may be able to see funds in your account in days or weeks, not the months it can take to secure equity financing.

Drawbacks of Debt Financing

Here’s what you need to consider about the negative side of taking out financing.

Payments Tie Up Your Capital

You need the capital to grow your startup, but right away you have to start making monthly payments on what you owe. If your loan term is 10 or more years, your payment won’t be as high each month, but it will still be money you can’t use to pay bills or invest in your company.

It May Be Challenging to Qualify

As mentioned earlier, startups sometimes have difficulty qualifying for traditional bank loans or SBA loans because they haven’t been in business long enough or don’t have the credit history required. While there are still some options that a startup might qualify for, they tend to come with much higher interest rates.

You May Put Your Assets at Risk

Many types of debt financing require collateral, which might be real estate or equipment. If you aren’t able to pay your loan, the lender has the right to seize that asset, which could jeopardize your ability to run your business.

Examples of Debt Financing

The good news is that there are many types of business loans, so your startup will have a number of financing options to consider.

Bank Loans

There are often the most difficult kind of funding for small business startups to apply and qualify for. Bank loans tend to approve applicants who have a credit score of 650 or higher and who have been in business at least one to two years.

SBA Loans

SBA loans, which are backed by the Small Business Administration (SBA), may be a bit easier to qualify for, with average credit scores for approved borrowers ranging from 620 to 440. And even if yours isn’t that high, you aren’t automatically disqualified. There are several loan programs available, including the 7(a) loan program.

Line of Credit

If you need some cash now and more in the future, a line of credit will give you access to funds, up to a capped amount, when you need it. You pay back only what you’ve borrowed, plus interest.

Merchant Cash Advance

If your credit doesn’t meet the requirements for the options above, one debt financing option that may still be available to you is a merchant cash advance. These are short-term loans with high interest rates and fees. But on the plus side, the qualifications are minimal, and you can see funds in your account as soon as the next business day.

Invoice Factoring

If your business sends invoices to clients to get paid, you may qualify for invoice factoring. With this financing solution, you sell your outstanding invoices to a factoring company in exchange for a percentage of the value of those invoices. Once the invoices have been paid to the company, you receive the rest of the value, minus the factoring company’s fee.

Debt vs. Equity Financing

When you’re debating debt financing versus equity financing, it really comes down to what your startup needs. In addition to working capital, are you looking for guidance and connections you don’t currently have? In that case, equity financing could pair you with a great partner who helps take your startup to the next level.Or does the idea of having more cooks in the kitchen, so to speak, make you cringe? Would you rather run the business on your own, even if it means taking on debt? A loan can provide you with the working capital you need without the hassle of someone second-guessing your business decisions. Whichever option you choose, have a plan for how you will use the money so that you can be smart about expanding your business and building for future growth.Leaning toward debt financing? Compare your options with Lantern today.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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About the Author

Susan Guillory

Susan Guillory is the president of Egg Marketing, a content marketing firm based in San Diego. She’s written several business books, and has been published on sites including Forbes, AllBusiness, and Cision. She enjoys writing about business and personal credit, financial strategies, loans, and credit cards. Follow her on Twitter @eggmarketing.