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Home Business Loans Equity Capital Vs. Debt Financing: What’s the Difference?
It’s common for companies growing faster than their current income to seek outside capital to keep up their momentum. An under-capitalized business will find it difficult to make the leap required to scale and expand.
A clear first step to lining up outside capital is to determine whether equity investment or debt financing (or a combination of the two) might be the best route for your business.
When you own a business concept or company, there’s a subjective value attached to it called equity. The equity of any type of asset—whether intellectual or physical—is the value someone is willing to pay for it, minus its liabilities. That could mean the value of an entity today (measured in time and money invested) versus its value in the future (measured by comparable growth).
Once the owner and investor determine the “valuation” of the asset, the owner can then sell parts of the equity to raise capital.
There are a variety of methods to raise equity capital, including seed capital, angel capital, and managed venture capital. Here’s a closer look at each of these popular equity financing solutions.
Seed capital typically comes from private investors (often personal sources like friends and family members) during the startup phase of a company’s development. It only qualifies as equity financing if the investor receives a piece of the company in return for its investment.
Angel capital comes from angel investors—typically high-wealth individuals who invest in businesses (startups included). In exchange for angel capital, an investor will require a piece of the companies in which they invest.
Venture capital funds come from managed, pooled investments. This type of funding is usually only available to startups with the potential for rapid growth and high returns. Again, you’ll have to give up a share of your business in exchange for the investment dollars you receive.
Debt financing is a source of business funding where a lender provides to the business an agreed-upon amount of money that is to be repaid over a period of time, in addition to any associated fees or interest.
Like equity financing, there are various ways to secure debt financing as well. Below are four popular debt financing options to consider for your business.
A business loan can provide you with a lump sum you can use to invest in your business. You must repay the money your business borrows, plus interest and fees, according to the lender’s terms.
Accounts receivable financing lets you use your business’ unpaid invoices as collateral to borrow a lump sum of money—often up to 80% of the invoice value.
Equipment financing can provide your company with asset-based borrowing solutions to purchase or lease essential business equipment.
A business line of credit is a flexible form of financing that lets you borrow up to a certain amount (a.k.a. your credit limit). However, you pay interest only on the funds you actually borrow.
Every business has to choose for itself whether equity financing or debt financing makes the most sense, and many companies opt for a mixture of both types of funding. There are risks with either option you choose.
If your business closes and it still owes outstanding debts, you may still have to repay those loans plus interest. The same isn’t true with equity financing. On the other hand, if you sell your business for a sizable profit, paying off shareholders could be much more expensive than the cost of paying off a business loan.
It’s up to you to weigh the pros and cons of each type of financing and figure out which solutions make the most sense for your business.
Lendio’s mission is to empower your small business by making small business loans simple by providing options, speed, and trust. Whether you are looking for an acquisition loan or a startup loan, Lendio offers hundreds of different loan products from a variety of lenders. Find out which business loan is best for you.
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Michelle Lambright Black is a nationally recognized credit expert with two decades of experience. Founder of CreditWriter.com—an online community that helps busy moms take control of their credit and finances—Michelle's work has been published thousands of times by FICO, Experian, Forbes, Bankrate, MarketWatch, Parents, U.S. News & World Report, and many more.
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