Every business needs capital for business continuity and expansion. Without capital, no business is sustainable. Capital is that fuel that drives any business. It’s the oxygen that every business needs to thrive and survive.
When the question arises of raising capital, there are only three options left for any business: Either use their own funds, opt for debt financing, or choose equity financing.
There is a great deal of debate among business experts and entrepreneurs about the viability and feasibility of raising funds via these three channels: Self-funded business is the most ideal and recommended way, but as we all know, it’s not possible every time, especially for a new business which is just starting up.
Now, the main question is: Between debt and equity, which should be the optimal option?
In this article, we will share what debt financing is, what is equity financing, and what is the Difference between debt and equity.
Besides, we will share our opinion and views on which is better between these two.
What Is Debt Financing?
Debt financing is the most common type of loan, wherein you essentially borrow money from a lender and promise to pay back with interest.
Most types of auto loans, home loans taken by individuals, is debt financing, which also happens in business.
What Is Equity Financing?
Equity financing involves trading a portion of your business for raising capital. In most of the venture capital led fundraising, equity financing is the mode of raising money.
Angel investors or VCs will give you funding if you agree to provide them with a share of your company via equity.
Understanding Debt & Equity Financing With An Example
Assume that a kid called Harry has five candies, and he wants to expand his assets to 20 candies.
In debt financing, Harry will take a loan of Rs 100 from his friend Mary and use that funds to buy 15 more candies. In this case, Harry will promise to return Rs 100, along with a pre-agreed rate of interest.
In the equity financing, Harry will evaluate the total worth of his assets of 5 candies, and then give a part of that, say 20% to Mary and get Rs 100 as fresh capital to buy 15 more candies.
Difference Between Debt and Equity
There are four significant differences between debt and equity financing:
Ownership: In debt financing, you are not giving away ownership of your business to anyone. Whereas in equity financing, you are willingly giving away a slice of your business to an investor for raising capital.
Payback: In debt financing, the business owner needs to pay back the money with interest, whereas in equity, the money is never paid back, per se. In equity financing, you do not pay back the money in its strictest form, but rather dilute your ownership.
Control: In debt, the lender has absolutely no control over your business and decision-making process. But in equity, the lender or the investor becomes a co-owner of your business and can influence your decisions.
Risk: In debt, often, you need to place collateral to get the loan. In case you cannot repay the loan and the interest, the lender has legal rights to take control over your collateral and/or assets. But in equity, even if you cannot deliver the promises, there is no risk to your assets and your money. The investors are equal participants in both loss and profit arising due to the fundraising.
Why Debt Is Cheaper Than Equity?
If we discuss and analyze the advantages of debt financing compared to equity financing more deeply, we will realize why debt is cheaper than equity.
The loan which a business takes from a lender under debt financing, is limited and finite. Although collateral is given, and there is an interest applicable as well, but slowly and gradually, the debt is repaid, and the relationship with the lender ends.
But in equity financing, the business is basically entering into a new relationship with the investor by selling a part of the company and making them co-owners.
This is limitless and eternal, and even though you can repay the money you raised by selling off the equity, there will always be a residual claim on the company’s assets. The investors are putting in a lot of risk by investing in the company, and in return, they expect much higher returns.
The answer to the question: Why is debt cheaper than equity lies in the fact that how badly you need the money, how soon you need it, and how much is your assets worth today.
Which Is Better: Debt or Equity?
Before making the final decision, ask these questions:
- How fast do you need the money?
Debt financing can be approved in hours, wherein equity financing may take weeks and months.
- How much money do you need?
80% of Debt financing is related to small amounts, while 80% of equity financing is related to big amounts and big stakes.
- Is money the only thing you need?
With equity financing comes the inventor’s expertise and experience, which is much more valuable than money.
- How big do you really want to become?
And lastly, it all boils down to ambitions and the vision for your business. If you don’t wish to part away from your business and it’s control, then equity can be a hard bargain. But if you are willing to sacrifice a portion of your dream to make it 4x, 5x bigger, then equity is the best thing to happen to any entrepreneur.
To clarify the difference between debt and equity, you can consult with business and investment experts at MSMEx, a one-of-its-kind micro-advisory platform.
Pick up ideas and suggestions from the sharpest business minds, and give wings to your business plans right away.
Book an appointment here at MSMEx