Finance

The Difference Between Debt Financing vs Equity Financing

Two main options can help you raise capital. Ampla explores the differences between debt financing vs. equity financing.

Jade Thomas

When it comes to raising capital for your business needs, it comes down to two basic options: debt financing, and equity financing. 

While many companies go with both, it’s important to understand the pros and cons of each option. It’s crucial that you are educated in both and don’t blindly select one or the other because someone else said you should.

Both options provide your company with cash, so the choice often comes down to which funding source is best for your company and the most accessible. You should also consider how important it is to maintain company control if you are its principal owner. 

This can be a difficult decision for many. We break it all down for you to make the best decision for your business needs.

Debt Financing

Debt Financing is when you borrow from a lender to help invest in your growth and pay it back in the future with interest. The most common form of debt financing is a loan. The lender most likely puts restrictions on the company’s activities to ensure the money stays within the business and is not used for outside opportunities.

As you can see, there are pros and cons to debt financing. Here are just a few that you need to think about as you search for the right financing option for your business.

The Pros of Debt Financing

One of the biggest pros of utilizing debt financing is that the lender has no control over your business. The relationship ends with the financier once you pay back the loan. This is quite attractive to a small business owner who does not want to give up any company ownership.

Another major benefit often overlooked is that business debt can create additional tax deductions because the interest paid on a business loan is tax-deductible. This may not have a huge impact on a company in its seed stage, but it will make a huge difference as you grow in your net profits and yield positive revenues.

Although debt financing comes with an interest rate, it is still worth it in the long run if it increases your revenue. For example, if you take out a loan of $350,000 with an annual percentage rate of 7.5%, but your return on the project is 22%, it is a lucrative risk. 

As you continue to take out loans and pay them back on time, this also leads to better rates and returns in the future. 

The Cons of Debt Financing

The biggest drawback of traditional debt financing is the loan requires repayment whether your company is successful or not. This can be risky for a business as things like facing hard times, a turn in the economy, or slow growth in your business puts a damper on your company’s future.

Another downside of traditional debt financing is that many conventional lenders require you to guarantee the loan. More often than not, you'll guarantee the loan with your assets, such as your money, vehicles, or family home. This is devastating if you default on the loan or do not repay the loan. This can still happen even if you are a limited liability company (LLC).

Additionally, a con of traditional debt financing is the terms of the loan could change over time. Variable interest rates can dramatically change repayment terms. Or, in the case of a revolving line of credit, it is not unheard of for a traditional bank to suddenly cut them off when you need the funds the most.

However, Ampla is none of this. Of course, we require payback, but repayment only occurs when you generate sales so there is no maturity or fixed repayment date. And if sales slow, so do your repayments. Also, Ampla does not require a guarantee on personal assets. Our goal is to partner with you to grow your business.

Debt Financing Options

Here are a few options for businesses looking for debt financing.

Term Loans

Term loans are a good choice if you are expanding and have strong earnings and good credit. They also have high borrowing limits, which is quite helpful.

Business Lines of Credit, like Ampla

Having a line of credit is a great and flexible way to meet short-term financing needs like purchasing inventory, increasing marketing efforts, or fixing broken equipment.

Personal Loans for Business

This is a great option for a new business looking to hang on to equity. However, the rates depend on your credit score and can be expensive. It also puts your assets at risk if the company defaults or cannot repay the loan.

Equity Financing

Equity financing is when you acquire capital from an outside investor in exchange for an ownership stake in your business. This type of financing is the right opportunity for your business if you are still in the earliest stages of the company or if there is a perceived higher risk in the business. 

But this doesn’t mean there are not any downsides. Let’s go through the pros and cons of equity financing.

The Pros of Equity Financing

Suppose you are just getting started and do not have existing revenue or are not yet profitable. Equity financing is sometimes the only option because it allows you to get third-party funding without profitability.

With equity financing, the investor only benefits from their investment if your company is successful. Because of this, the investor is more inclined to help you make decisions and support your business for mutual benefit.

One of the biggest draws of equity financing over debt financing is the flexibility in distributions. Because there is no stress of a loan payment, you are empowered to make wise decisions for your company instead of rash decisions that may cripple your business.

The Cons of Equity Financing

The biggest con to equity financing is the loss of control. Your company is one pie, and equity financing means you must give up a piece. If you give up too many shares, this results in a loss of decision-making control. Your partners could ultimately replace you if you do not retain enough board seats or voting power.

Some investors may put in the financing agreement that they will be entitled to any positive returns before retaining profits for themselves. This is very difficult for many new entrepreneurs.

Finally, another disadvantage of equity financing is the time it takes to get the capital and find a willing investor. You may have to knock on a lot of doors before you find someone who wants to join you on your business adventure.

Equity Financing Options

Here are just a few options when it comes to equity financing.

Angel Investors

Angel investors are investors with a significant amount of money, and they look to provide financing for startups and small businesses. They are either a wealthy individual or a group looking to invest in a riskier business to a higher return on their investment.

Venture Capital

This type of financing is from investors, individuals, or firms that invest from a pool of money. These investors are more inclined to invest in established businesses or believe in having long-term growth potential. 

Family and Friends

This option is helpful if you have trouble getting in front of investors with the money and power you need. The downside is that if the business fails, this could put a strain on your relationship.

The Bottom Line

There are many advantages and disadvantages to debt financing and equity financing. You should decide on the best choice for your business after careful consideration and lots of research. 

Growing Responsibly

There are so many options for financing your small business. It can be quite hard to choose the right option for you and find the right lender that will support you. 

It can be discouraging when traditional banks won’t even entertain your ideas because of the risk of being a start-up. Set up a call with Ampla to see how we can help you grow.

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