Debt Funding Vs Equity Funding: What's The Real Difference?
Debt funding Vs Equity funding– Which is the best financing option for my business? This is a question which every business would have especially during the initial phase of establishment. Every business requires capital now and then and choosing the right kind of funding is imperative for your financial stability and business health.
Small businesses and startups are often victims of impractical lending standards and the recessionary fallouts making it extremely difficult for them to thrive in the market and grow. The question about whether you should take a loan for business expansion or look out for a potential investor for your business, always persists. Let us now understand the fundamental difference between the two and help you analyse which would be best for your business funding.
Basically, if you borrow money from a bank, financial institution or a lender with an intent to pay back with a stipulated rate of interest you have opted for debt funding. There are two major types of options in debt funding in India you need to know about:
- Secured Funding: Through this, you would be offering the lender some kind of security or collateral to assure repayment of the loan. This collateral offered to the debt funding companies can range from providing a guarantor or an endorser, co-applicant, offer an equipment which provides them with around 65-70 per cent of its total value as collateral, securities like stocks or bonds, insurance policies, merchandise or lease payments on the property you wish to lease.
- Unsecured Debt Funding: Through this, your lender relies only on your credit reputation for passing the loan. This kind of debt financing is usually for a very short period and a limited amount of money at an exorbitantly high rate of interest
In the case of an equity funding, you are raising funds through sales of shares and ownership interest. The shares not only refer to the equity shares but also include preferred stocks, convertible stocks, and other such quasi-equity instruments. You would be looking for potential angel investors and venture capitalists who would be interested in your business. If this is what you want to go for you have to further consider whether you would prefer equity funding through family and acquaintances, venture capitalists, look out for angel investors to back your venture, SBA financing, or go for royalty financing. You can also consider Mezzanine financing to have a balance between equity and debt funding.
Debt Funding Vs Equity Funding- All you need to know
Now that we have discussed the basic definition of both the modes of funding, let us probe further and understand its differences more clearly.
#1. Company ownership
This is the first point of discussion we must enter into when we are having the equity funding Vs debt funding debate. In the case of debt funding for start-up, you would be getting a loan to be repaid back with interest. Here the ownership of the entire property lies with you and no one else can claim any rights over it. You don’t have to compromise on the equity you earn or build in the company. However, in the case of equity financing, you are sharing your ownership with the investors and venture capitalists who invest in your company by purchasing equity shares and stock options. You are thus liable to distribute a chunk of your profit to your shareholders.
#2. Mode of raising fund
The basic difference between an equity and debt funding for business depending on how you get the money. With debt funding, you are borrowing money which has to be repaid. While with equity financing, you are raising money by attracting investors to invest in your venture.
#3. Risk of funding
Every financing option comes with its own share of risks and analysing this while analysing debt funding vs equity funding is crucial. You have to understand the risks involved and who it would affect directly before choosing a financing option. Debt Funding for start-ups comes with an interest rate and has to be repaid in a pre-determined period of time. However, for a start-up, this might be difficult as they might encounter periods of high and low cash flow and would have to always set apart the installments no matter how the business cash flow is.
On the other hand, with equity financing, the entire risk falls on the shareholders and investors as there is no obligation of repayment. Your investors will get their return in case your venture succeeds. This is the best option in case you don’t have limited revenue, little or no profitability to secure a good chunk of money to support your business. But if you have more shareholders, the lesser would be your power to make decisions on the operations of your business.
#4. Ongoing profits
Understanding how your financing option would impact your ongoing profit is imperative before you make your decision in the debt funding Vs equity funding debate. If you choose debt financing, your entire profits would remain within the company as you have control over all your equity holdings. In addition, the interest costs can be listed as a tax write-off. In the case of equity funding, you may not have to divert your revenues to pay loans. However, you still have to share your profits with your shareholders.
#5. Relationship with the financial institution or lender
In the case of debt financing, your relationship with the debt funding companies is only temporary and will end the minute you finish paying back the installments. However, with equity funding, the investors become shareholders of your company and will be a part of your business. If you have a difference of opinion with the investors you might have to cash your portion of the business and let them run it without you. Even otherwise, you can’t function without getting their approval in all business operations. Sometimes these equity financing options cost more than what you would have to pay in debt funding.
There are a lot of things to consider when you go through the debt funding Vs equity funding debate for your business. Debt equity is less complex and more predictable when compared to equity funding. However, some companies would still choose investors over debt funding companies in case they require a huge chunk of money and zero profitability. You can also go for a mix between the two to balance the negatives of the other and also get adequate funding for your business.
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