What Is Equity Financing? Debt vs. Equity Financing

Susan GuilloryUpdated April 21, 2023

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Both equity and debt financing can give you the funding you need to grow your business, but they work in very different ways. With equity financing, you sell shares of your company to investors to raise capital. If you use debt financing, you borrow money from a bank or other lender and pay it back over time with interest. Which option makes the most sense for your business will depend on several factors, including the stage your business is at and how much capital you need.Keep reading to learn more about how equity and debt financing work, the pros and cons of each, and how to choose the right source of funding for your venture.

What Is Equity Financing?

Equity financing (also called equity funding) is when an individual or company invests in a business 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. They are also entitled to a share of the company’s profits.To raise capital through equity financing, you need to find investors who are interested in your business, which involves pitching your business. If an investor decides to fund you, they would give you an agreed upon amount of money for a certain amount of ownership, or stake, in your company. The amount you can raise and the percentage of ownership that you give will depend on the investor and how much your company is worth. Investors are essentially paying for a percentage of your company's future profits.Recommended: 13 Ways to Fund a Startup

Benefits of Equity Financing

Here’s a look at some of the advantages of equity financing.

It Opens the Door to the Capital You Need

If your company is new or just getting off the ground, you may have difficulty finding debt financing that you qualify for (especially at a low interest rate). But equity financing was designed with startups in mind. Investors also tend to provide more funds than a bank might loan you, which means that equity financing may give you all the funding you need to launch or grow your business.

It Gets You Access to Industry Experts

Investors tend to invest in industries they know well. That’s a potential boon for you because your investors may be able to provide operational expertise you lack and make introductions to potential partners or customers in your field.

The Funds Don’t Have to Be Paid Back

With equity financing, you don’t have to pay back the funds you receive or pay interest on those funds. You will, however, be required to share future profits with investors.

Drawbacks to Equity Financing

Though equity financing could be the solution to getting the capital you need, there are a few potential downsides 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 down the line.

You’re Not the Only Decision Maker

While having investors who have experience and contacts in your industry can be a good thing, it does add more voices and opinions to the mix. Instead of you (and maybe a cofounder) calling all the shots, you may now need to take your investors’ opinions into consideration.

It’s Slow

Acquiring equity financing is often a long, drawn out process. You typically need to organize all of your financial information, create an impressive deck, and make a compelling pitch to multiple parties to find the right investor. Then, if you do get a bite, you’ll have to negotiate terms. Recommended: Business for Sale: Owner Financing, Defined and Explained

Examples of Equity Financing

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

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

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. The investor typically exits the company after a period of several years by initiating a merger, acquisition, or IPO.

Angel Investment

An angel investor is typically a high-net-worth individual who invests money in a business with high growth potential, typically in exchange for ownership in the company. Unlike a venture capitalist, an angel investor uses their own money to invest in the business. Many angel investors look to invest in early-stage startups.

Convertible Debt

Another example of equity financing is convertible debt. With this type of hybrid financing, a lender or investor gives a startup a loan. If the business meets certain performance goals, they will then convert the unpaid balance of that loan into an equity stake in the company. If those benchmarks aren’t made, the startup must repay the loan.

What Is Debt Financing?

Debt financing involves taking out a loan or line of credit from a bank or other lender that your business must pay back, along with interest. With a traditional term loan, the business receives a lump sum of money up front then repays the loan in regular monthly installments (that include both principal and interest) over the term of loan.

Benefits of Debt Financing

Debt financing comes with several advantages. Here are some to consider.

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 lenders when making decisions about your business. Once you repay the loan, your relationship with the lender ends.

There May Be Tax Advantages

The interest you pay on debt financing is typically a tax-deductible business expense, which means it can lower your tax bill at the end of the year.

It’s Fast

Getting debt financing is typically a faster process than getting equity financing, which involves identifying and pitching to investors, then drawing up documents outlining the equity agreement. If you choose a small business loan from an online lender, you can often get funded in a matter of days.

Drawbacks of Debt Financing

Debt financing also has some drawbacks that you’ll want to keep in mind.

You Have to Repay the Money

With a loan, you have to pay the money back in full, plus interest, and often according to a set schedule, no matter how well your business is doing. Should you experience a dip in cash flow and miss a payment, you can get hit with a hefty fee.

It May Be Challenging to Qualify

If your business is new or just getting off the ground, it can be difficult to qualify for a traditional bank loan. These loans often require at least two years of business history, excellent credit, and a minimum amount of annual revenue. Online lenders generally have more flexible criteria (and some even offer startup loans) but generally charge higher interest rates and offer lower loan amounts.

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 repay your loan, the lender has the right to seize that asset, which could jeopardize your ability to run your business.

Examples of Debt Financing

There are many different types of business loans. Here are some options you may want to explore.

Bank Loans

These are often the most difficult kind of funding for small businesses to 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 two years. However, these loans typically come with some of the most attractive rates and terms.

SBA Loans

SBA loans are business loans partially guaranteed by the U.S. Small Business Administration and issued by participating lenders, usually banks. Because these loans represent less risk to the lender, they can be easier to qualify than regular bank loans and offer flexible terms, large loan amounts, and low interest rates.

Line of Credit

A business line of credit is a flexible form of financing that allows you to borrow money as you need it up to an approved limit. You only pay interest on what you actually borrow and, as you pay the money back, it’s available to borrow again.

Merchant Cash Advance

If you need cash quickly and your business involves credit or debit card sales, you might consider a merchant cash advance (MCA). With an MCA, a financing company gives you a lump sum of cash up front that you repay using a percentage of your debit and credit card sales, plus a fee.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 often comes down to the nature of your business and its stage of development. If you’re looking for working capital as well as guidance and connections, equity financing could be the perfect solution that can take your business to the next level.If you don’t like the idea of giving up ownership of your company — or having more cooks in the kitchen — and can qualify for financing, you may be better served by a small business loan.If you’re curious about what type of small business loan you might be able to qualify for, Lantern by SoFi can help. You can use our fast online search tool to get a personalized small business loan option in minutes.Let Lantern help you find the right financing solution for your small business.

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About the Author

Susan Guillory

Su Guillory is a freelance business writer and expat coach. She’s written several business books and has been published on sites including Forbes, AllBusiness, and SoFi. She writes about business and personal credit, financial strategies, loans, and credit cards.