• Financing for small businesses often falls into two broad categories: debt financing and equity financing. 
• Each has pros and cons, including how they affect ownership, cash flow and even taxes.
• Here’s how each type of funding works, and how to decide what’s right for your unique business and goals. 

Is Debt or Equity Financing Better for Small Business? 

With debt financing, you borrow a fixed amount of money from a lender. You pay it back with interest, or the financing company will charge fees.

Note: There is a type of debt financing where businesses raise money by selling bonds. This is not common among small businesses. Here, when we talk about debt financing, we’re talking about borrowing money from a lender.

With equity financing, you’ll bring in money from investors. Typically you’ll give them some ownership in your business in exchange for that funding. 

Each one has a place in the small business financing ecosystem, and what’s right for your business depends on your business model, goals and qualifications. 

Let’s look at each one more closely.

Equity Financing    

Equity financing involves an investor (or investors) who invest in your business. You don’t pay  interest or fees. Instead, you’ll typically provide the investor with shares (equity) so they’ll have an ownership stake in your business. They will make their money back from future profits, if the business goes public in an IPO, or if there is an acquisition. 

Types of Equity Financing

There can be several sources of investor capital;

Friends and Family

If you have friends and family members that believe in your venture, they may offer to back our business. 

It’s also very important to spell out this relationship clearly in writing. You don’t want to be in a situation where they think they are lending you money, but you think they are investing in your business. 

Angel Investors

Angel investors are wealthy individuals or groups who choose to put money into startups and small businesses. They are often the first outside investors in the business. So, they’re more likely to share helpful advice and connect you to others in your industry. 

Venture Capital Firms

Venture capital firms (or VCs) invest in entrepreneurs and new businesses or young businesses that are expected to grow quickly, and make a lot of money. VCs are usually very particular when screening businesses, and invest in a very limited number of companies. 

Crowdfunding

Investment or equity crowdfunding allows small businesses to raise money from a wide variety of investors. Deals can be structured in a variety of ways as well. 

Crowdfund Capital Advisors reports that an impressive 70% of Regulation CF crowdfunding campaigns succeed. While crowdfunding takes time, and has its own set of challenges to be successful, this positive track record is impressive.

When Would a Company Prefer Equity Financing Over Debt Financing?

There are several pros of equity financing that may lead a business to choose this type of funding:

No Repayment Required 

If you opt for equity financing, you won’t have to make loan payments, or pay interest and/or fees. With no repayment requirement, cash flow may remain stronger.

Creditworthiness Not Required

Investors are looking for early-stage businesses with the potential to make a lot of money, and even IPO. They are more interested in the business plan and the founder’s experience than in their credit history. 

Valuable Business Advice

Chances are your investor has experience helping business ventures succeed. They’ll likely share their wisdom with you and help you make informed decisions. In addition, they will likely connect you with others in your industry and help you expand your knowledge and experience. 

Larger Funding Amounts

In most cases, investors invest large amounts of money into businesses. This can be a major advantage if your business needs to hire many individuals or invest a lot of cash into a product. 

Cons of Equity Financing

There are a number of potential disadvantages of equity financing. 

Loss of Ownership

When you depend on investors for capital, you are no longer the sole owner of your business. Every time a new investor comes on board, your business ownership becomes more diluted. 

Diluted Decision-making

With equity financing, investors may have the power to make business decisions, and you can face problems if you don’t agree. Lenders don’t have control over your business decisions like investors may. 

Difficult to Obtain

Investors, especially venture capitalists and other equity investors put a lot of money into the businesses they invest in. Therefore, they are often selective and may not choose your business unless it has high growth potential. 

It can take months, or even a year or more, to raise money from investors. Most investment crowdfunding campaigns take several months start to finish. 

Debt Financing    

If you opt for debt financing, you borrow money from a lender to gain the capital you need. You’ll pay back the amount you borrow plus interest payments and fees by a certain time period, which is typically a few years. 

Debt financing is usually available through banks, credit unions, non-profit organizations, and alternative lenders. Depending on the type of financing, you may receive a lump sum of money or have access to a revolving form of credit.  

Types of Debt Financing

There are numerous ways to borrow money for your business.

Business Lines of Credit

One of the most popular types of small business loans, a line of credit allows your business to draw funds against a set credit limit whenever you’d like. This is a flexible financing option that’s especially useful for working capital or emergency expenses. 

Term Loans

With a term loan, you get a lump sum of money and repay it over a set time period. A term loan may be a good choice if you have to make large purchases like equipment or real estate. 

Business Credit Cards

A business credit card makes it easy to pay for purchases. You can buy office supplies, inventory, and anything else you need up to the set credit limit. You’ll repay any funds you use. If you use it to pay for purchases over time, Interest will be charged balances. Most business credit cards come with cash back or point rewards. 

An advantage of business credit cards is that they are usually available to brand new startups. 0% APR business credit cards can provide several months of interest-free financing. 

Invoice or Receivables Financing

If you choose invoice or receivables financing, you’ll pre-sell your unpaid invoices to a lender in exchange for a lump sum payment. Essentially, this option turns your unpaid invoices into fast cash that you can use for short-term financing needs.

Merchant Cash Advance

With a merchant cash advance, you receive a lump sum in exchange for a percentage of future credit card sales or revenues. Compared to a term loan, a merchant cash advance typically has smaller payment amounts and shorter terms.

SBA Loans

The U.S. Small Business Administration has an extensive SBA loan program including 7(a) loans, CDC 504 loans, SBA Microloans, export loans and more. These loans are made by lenders approved by the SBA, with the guaranty coming from the SBA. You apply for SBA loans through lenders not the SBA (except for disaster loans).

Vendor Terms

Short-term loans from your vendors or suppliers can help with cash flow. Repayment terms can range from net-10 to net-180 or longer. (Net-30 terms gives you 30 days from the invoice date to pay.) 

Microloans

Microloans are smaller loans, usually made by non-profit lenders trying to help spur economic growth by working with underserved entrepreneurs.

Crowdfunding 

Crowdfunding can be used to raise money from lots of different individuals or investors. Top types of crowdfunding for small business include debt-based crowdfunding, investment-based crowdfunding, and rewards-based crowdfunding. 

Why Would a Company Choose Debt Instead of Equity Financing?

The are several significant advantages of debt over equity financing:

Retain Full Ownership

The lender won’t own a portion of your business so you’ll retain your equity, which could be as much as 100% ownership if you are the sole owner. This means you’ll get to make all the decisions and keep all the profits. 

Tax Deductions 

Typically, the principal and interest you pay on a loan are considered business expenses. You can likely deduct these expenses from your business’s income and save some money on taxes.  

Short-Term Obligation

Once you repay the money you owe, you’ll have no obligation to the bank, credit union, or other entity that loaned you money. You can move forward with your business without owing them anything. 

Build Business Credit

If the lender reports to business credit bureaus, on-time payments can help you establish business credit. 

Many Options

Since there are lots of types of business financing options, most business owners can find something their business qualifies for. While bank loans can be hard to get, there are many different options that may be available to business owners with less than perfect credit. 

More Flexible

You aren’t tied to a particular business structure to get business financing. Some lenders will even lend to sole proprietorships (though others do require your business be structured as a formal business entity, such as an LLC or corporation.)

Fund Quickly

While loans from traditional financial institutions take time, some types of business financing can fund in hours, or within a couple of business days. If your business needs money yesterday, a loan or merchant cash advance will definitely be more appropriate than trying to raise money from investors. 

Cons of Debt Financing

When it comes to the disadvantages of debt financing, here are the most important ones:

Payments Required

You may need to make daily, weekly or monthly payments, depending on the terms of your loan or financing. This can be hard for pre-revenue businesses or businesses with fluctuating cash flow. 

Interest and Fees

Unless you have stellar personal and business credit, you may face high interest rates and/or fees. You must make sure you understand how those additional costs impact your profitability.

Collateral

Depending on the type of debt financing you obtain, you may have to pledge assets of your business to the lender as collateral. If you default on your loan, the lender may take your collateral. 

Credit Impact 

If you fail to make timely, full repayments, your business credit scores may take a hit. This can make it difficult for you to borrow money with favorable rates and repayment terms in the future. 

Cash Flow Challenges 

It’s unlikely that your business earns the same amount of money each month. However, most lenders expect equal repayments every month. If your business experiences drastic cash flow fluctuations from month to month, debt financing can be risky.

Restrictions

It is possible that the lender will restrict your use of funds. For example, an equipment loan can only be used to purchase specific equipment. 

Debt vs Equity Small Business Financing: Implications for Taxes

Both debt and equity financing have specific tax implications. 

Interest and fees on business loans are usually tax deductible to the business, whether the business structured as a sole proprietorship, partnership, LLC or corporation (S corp or C corp). 

With the exception of C corporations, most of these entities are considered “pass through” entities for tax purposes. That means profits and expenses from the business flow through the owners (members or shareholders) personal income tax returns. 

Investors, however, often want to invest in C Corporations, for a number of reasons, including unlimited number of shareholders and different classes of shares. It’s likely your business will need to be formed as a corporation and taxed as a C corporation to raise money from angels or VCs. The corporation pays corporate income tax, and shareholders (or owners) pay income tax on dividends. 

Read: S Corp versus C Corp What’s the Difference?

Which Type of Financing Should a Company Use?

Now that you know the difference between equity financing and debt financing, you may be wondering which option is right for your business. 

First, understand that these are two completely different approaches to funding a business. It’s not an apples-to-apples comparison. 

Also understand that equity funding is most appropriate for business owners who are starting businesses that are attractive to investors. The business should have a scalable business model and plans to grow quickly, but needs a larger amount of capital in the meantime. 

It is hard to land venture capital, but your business may be able to raise money through equity crowdfunding or private investors (such as friends or family.)

With equity funding you don’t need to take on debt and make payments. 

Debt financing, on the other hand, may be ideal if you do not want to give up ownership in your business. It’s also a strong pick if you need financing quickly. 

Another advantage: you may not need to change your business structure. Even sole proprietors may be able to get business loans, business credit cards or financing.

Would You Rather Use Debt or Equity to Finance Your Business?

The reality is that most small business owners won’t have a choice between debt or equity financing. Most businesses in the US aren’t likely to make enough money fast enough to attract outside investors. And many entrepreneurs simply don’t have the connections or experience to attract investment capital. 

Business loans may be the best way to get the money you need to launch or grow your small business. Fortunately, there is a wide variety of loans and financing that may help at all stages