When it comes to taking out a loan, one of the primary distinctions is between debt and equity financing. Debt financing involves taking out a conventional loan via a bank or other traditional lender, with recurring payments used to work down the balance over time and an interest rate applied to cover the risks associated with the loan. By contrast, equity financing centers on giving up a percentage of company ownership in exchange for capital.
Debt financing typically involves careful consideration of credit history and other aspects of one’s financial situation. Not every application for traditional bank financing is approved: accounts that lack the short- or long-term capacity to pay back the principal are deemed credit risks and are often declined.
Given this dynamic, many startup ventures and businesses at the beginning of their earnings lifecycle, but with significant potential, seek out equity loans. In equity financing, it typically takes longer to receive a loan decision, reflecting the work involved in bringing together interested investors and negotiating percentage of ownership in the company based on the amount of money flowing in.
Depending on the terms agreed upon, equity investors may also gain a voice in the invested company’s strategic direction, through holding board seats or other leadership capacities. This runs the risk of diluting the original vision for the business and may cause disputes and delays in decision making. On the other hand, the equity investors may bring significant technical or market knowledge to the table, as well as relationships with industry participants, which can accelerate growth potential.
Debt financing, by contrast, enables the business owner to maintain full control of their enterprise. The lender is only entitled to repayment of the loan principal plus interest, at an agreed-upon rate, and does not lay claim to future business profits. Should the business exceed expectations, in terms of generated revenue, the owners retain a larger percentage of the profits than they would have had they allocated a percentage of the company to investors as a way of financing operations.
On the flip side, the principal and interest obligations associated with debt financing (except when variable rate loans are involved) are easier to forecast and plan for. The exact amount of interest due is known ahead of time and tied to an agreed-upon payment schedule. That said, the offered interest rate may not be ideal, depending on credit rating and how long one has been in operation. With poor credit or with a minimal track record, given the compound nature of interest in adding to the principal owed, the cost of such a loan can be a major burden that significantly hampers cashflow.
There are also numerous technicalities, linked to taxes and regulations, that influence which option is better for a specific company. Interest on debt loans is deductible on the corporate tax sheet, reducing the total cost the company bears. Unlike with equity investments, there are no onerous state and federal laws for the debtor to navigate, as these are already covered on the lending party’s end. In addition, the company does not need to hold meetings periodically nor send out reports to investors, and it does not require voting by shareholders before taking specific actions.
