Seeking funding: Should it be debt or equity?

Many businesses owners every year face the same dilemma when they need to raise capital; should they acquire funding through debt, or through releasing equity in their business. This is especially true for new startups but is also a quandary established businesses must decide upon when looking to grow.

Each option offers pros and cons and it will depend on the business needs and the amount of finance required but let’s just take a closer look at both.

Debt financing is the acquisition of capital by borrowing money that must be repaid in the future. Typical examples of this method of securing finance are loans and credit. A big advantage of debt financing is the fact that it allows owners and directors the opportunity to leverage a small sum of money into a much greater amount which allows the business to grow a lot faster than it would be able to without the injection of capital.

Other significant advantages that debt financing has over equity is that business owners retain full ownership and therefore control over their business. Traditional forms of debt financing ensure you don’t give up any part of your business in return for the funding and although finances might be difficult due to the repayments in the short term, at the end of the day your business is still 100% yours.

This is extremely important for startups because of the emotional attachment they have to the business. It’s their baby so to speak, which makes it difficult to surrender any portion of the business in exchange for capital, especially since sacrificing so much in striving to get the business started. Bearing this in mind, you can understand why so many budding entrepreneurs prefer to raise capital through debt financing as opposed to equity.

The negative aspect of debt financing is the interest on the debt means the amount that must be repaid is significantly greater than the original sum borrowed. A point to remember here is that repayments must be maintained regardless of how well the business is performing and this can prove damaging to small businesses.

The philosophy behind this type of financing is that the money will ensure the growth in production and ultimately turnover, will mean the increase in profits will outweigh the cost of the interest repayments.

Equity capital, on the other hand, is finance raised by selling stock in the company. This method may initially seem extremely appealing because it doesn’t involve repayment of funds and won’t put any additional strain on the cash flow of a business. The majority of Angel Investors are only too eager to invest in new startups in return for equity. They are a very popular choice for new business owners, especially those looking for smaller amounts of funding.

However, just like debt financing, there is a downside. By receiving funding in exchange for equity, control over the business becomes diminished and the responsibility to the new shareholders means the business is under greater pressure than before to deliver results.

A point to note is that since the risk to the investor in equity financing outweighs the risk to the lender in debt financing, the amount of equity demanded is usually greater than the debt. In fact, in many cases, prospective investors can request up to 50% of the business and it is down to both parties to negotiate and reach an amount that they agree upon.

As mentioned earlier, both equity and debt financing have benefits and disadvantages and your business needs and personal circumstances will dictate which path you decide to take.

If you require further advice on seeking funding, please contact one of our experts.