As a person who is exploring business financing options, you are likely to find yourself having to make a choice between equity financing and debt financing. These are the two major options available to you, when it comes to business finance. There are other minor options, of course: things like bootstrapping, crowdfunding… and so on. But we all know the limitations associated with those other minor business finance options, especially with regard to the amounts of money that can be raised through them. This is why I have come to the conclusion that if you are looking for serious money to do business with, you will probably end up having to make a choice between equity financing and debt financing. And that is where you are likely to end up having to seek answers to the question as to which of the two options is better. This article tackles that question.
Understanding the concept of equity financing
At its core, equity financing entails inviting investors to put their money in your business enterprise, in exchange for a stake in it. Equity financing can therefore be visualized as being akin to selling shares in the business, in exchange for capital. The investors who put money in the business under the equity financing model therefore become shareholders, who are entitled to a share of all the profits that the business will be making in the future. They expect to get portions of the future profits, commensurate with the money they will have put into the business venture. And to ensure that the business venture performs well enough to give them their money back, they may demand to be given some managerial control over it.
Understanding the concept of debt financing
At its core, debt financing entails borrowing money from lenders, and putting the money into the business. In exchange, you promise to give the lenders their money back, with a bit of interest, once the business starts generating revenues. To be sure that they will get their money back, the lenders may demand to be given some sort of collateral. Once you manage to repay the lenders’ money, with the applicable interest, the lenders will release the collateral back to you. Unlike the investors under the equity financing model, the lenders under the debt financing model don’t really have a long-term stake in the business. Once you repay their money (with interest), you are done with them. They won’t demand a share of the profits on an ongoing basis.
Pros of Equity financing
The main advantage associated with equity financing is in the fact that it is less risky, compared to debt financing. With equity financing, when you get the investors to put their money in your enterprise, you essentially make them shareholders (co-owners) in the business. If the business does well, they will get a share of the profits. And if the business does badly, they will get a share of the losses. But, having invested their money in the business, they can’t demand it back. That is unlike the lenders, who will want their money back, whether the business does well or not. Under the debt financing model, if the business fails to perform well (as is often the case), you can be sure that the lenders will torment you greatly. They may go as far as reporting you to the credit bureaus, thus messing your credit score up. If you gave them some collateral, they are bound to sell it, to recoup their money. They do that all that, regardless of your business’ performance.
Cons of Equity financing
The main disadvantage associated with equity financing is in the fact that the investors who put their money in the business usually expect too big a stake, in exchange for modest financing. And having put their money into the business, they become lifelong stakeholders: meaning that, for the remainder of the business’ life, they will be expecting to get a share of the profit. You will never get to shake them off. The investors are therefore unlike the lenders (under the debt financing model), who are done with you the moment you repay their money. Furthermore, as we hinted earlier, the investors under the equity financing model often demand to be given control of the business, so as to ensure that it is managed in a manner that protects their interests. This means that the moment you accept equity financing, you have to be ready to loss full control of the business. Eventually, it may get to a point where you are completely ousted from the business by investors!
Pros of Debt financing
The main advantage associated with debt financing is in the fact that the lenders don’t demand a stake in your business, in exchange for their money. All they demand is to be repaid their money, once the business starts generating revenues. The moment you repay them fully, they get off your back, for good. They have no further interest in the business: unlike the investors under the equity financing model, who demand a share of the business’ profits in perpetuity. So, having opted for debt financing, you remain in control of your business, and you don’t run the risk of ever being ousted by anyone.
Another advantage associated with debt financing is in the fact that it is usually easier to secure than equity financing. The lenders are in the business of hiring out their money, and once you show them a sensible business plan, (ideally backed by decent collateral), you can be assured that they will give you the funds you need. On the other hand, with the investors under the equity financing model, you have to be really persuasive, to get them to put their funds in your business (because, for them, the risk is higher).
Cons of Debt financing
The main disadvantage associated with debt financing is in the fact that the money you get from lenders comes at a huge cost: in terms of the expected interest rates. Furthermore, on your side as a business person, the risk is higher, if you opt for debt financing: as you may end up being declared bankrupt, if you are unable to meet your obligations. If you are unable to meet your debt obligations, you are certain to be reported to the credit reference bureaus, dealing a blow to your future borrowing aspirations. The lenders, unlike the investors under the debt financing model, won’t care whether your business performs well or not: they will demand their money back, once the repayment time comes.
The better option
In trying to make a judgment as to which is the better option – between equity financing and debt financing – you have to look at the advantages and disadvantages of both options. I have highlighted the major pros and cons to each financing model. Ultimately, you will have to look at your unique circumstances, as a businessperson, to figure out what the best option for you is.