Debt or Equity Financing. What Is The Best Approach for a Small Business?

Last Updated: February 16, 2021

Borrowed capital and equity capital are two of the available options for raising the required startup capital for a small business. They are different approaches, and you have to understand their drawbacks, differences, and benefits before getting started. The primary difference between the two financing options is whether to pay to obtain them.

What does equity financing entail?

Equity financing is the act of selling a portion of a company's equity to an investor. In this case, the investor provides the capital needed by the company for development while, in return, they acquire a stake in the business. Through this, the investor gets a seat at the table for all the company's future business decisions. This comes with various benefits as well as disadvantages to the company.

Pros and Cons

One of the benefit of the equity approach is that there is no repayment since the investors become shareholders in the company. The other benefit is that since there are no repayments, there is no interest fees accrued on the capital. Lastly, there is more capital. On the downside, some of the cons include decision-making issues as the investor has to be involved in all decisions made by the company’s owner. Another disadvantage is the sharing of profits, and also there might be opinion differences between you and the shareholders.

What is debt financing?

Debt financing means borrowing capital for your start-up and repaying it with added interest fees. In this category, standard loans are one type of debt, as are many daily funding opportunities such as mortgages.

Pros and Cons

To start with pros, there are various reasons as a business owner you may prefer this approach. Some of these reasons include independent decision-making as the debt capital provider does not have a say on how to run the business. Another benefit is that there is no sharing of profits. In debt financing, the owner takes debt willingly and agrees to the terms of repayment and interest rate.

Therefore, there is no profit-sharing. Lastly, there is easy budget forecasting. Notably, once the plan for the debt repayment is settled, there are no changes, which makes budget forecasting easier. Since there is a pre-determined monthly fee, the company's future expenses become more predictable.

On the demerit side of this approach, some of the drawbacks include; repayments where unlike with equity strategy, you have to pay the initial capital per the agreed repayment schedule. Another drawback is the interest the debt generates depending on your loan rate, and the interest expenses which vary depending on the method used to calculate interest.

Finally, there is the aspect of liability. Notably, even if your business structure limits your personal liability in the event of a lawsuit, some lenders record assets as collateral. In this case, if you fail to repay the loan, the lenders may take your assets.

What are some of the questions to consider before choosing either strategy?

As illustrated earlier, both approaches are among the most common options available for raising capital for a business startup. However, each of them has various drawbacks and advantages, and it is upon you to choose which option is the best for your business. In this case, you should consider some questions before choosing either approach. Some of these questions include;

What is the best approach for a small business between debt and equity financing?

With some of these questions, you will be able to choose the best options for your business startup. However, for a small business, the former is the ideal form of financing since there is no room for sharing a portion of the company with the finance providers. Besides, you get all the authority to run your business independently. Lastly, the business is small, and therefore profit-sharing can jeopardize business growth.


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