What is Equity Financing vs Debt Financing?

If you are starting a business and are looking at your financing options, there are two types of financing available: equity financing and debt financing.

Debt Financing
Debt financing means taking out a loan (money that is to be paid back over a certain period of time, usually with interest). Debt financing is either short term (the loan is to be repaid in less than a year) or long term (the loan is to be repaid in more than a year). Lending parties will also look closely at the business's debt-to-equity-ratio.

When taking out a business loan, the only obligation of the business is to repay the loan according to the terms that were agreed upon. The lending party does not gain ownership in the business.

Many lending institutions require the owner(s) of smaller businesses to personally guarantee the loan. In such a case, the commercial loan becomes the same as a personal loan.

If you are starting a home based business and are looking to take out a commercial loan, then you will be definitely be asked to personally guarantee the loan.

Advantages of Debt Financing
The biggest advantage of debt financing is that the lending party does not gain any part of ownership of your business and your only obligation to lending party is to repay the debt. Also, repayment of the loan is typically a fixed expense, according the terms of the loan.

Dis-Advantages of Debt Financing
The biggest dis-advantage is that the business will not have all of its cash flow available to do business. Also, the interest that is owed can be high.

Equity Financing
Equity financing is when you (the business owner) sell an ownership interest in your business in exchange for money. The business owner and the investor(s) shares the business and the risks that come with it.

Equity financing is a form of financing your business without incurring debt. With equity financing you don't have to take out a loan since the funding is already coming from an investor in exchange for a piece of ownership in the business.

Many small and growth-stage businesses use equity financing as a source of funding. There are many sources of equity financing including non-professional investors such as family and friends, employees, etc. The most common source, however, are professional investors known as venture capitalists.

Venture capitalists are looking for businesses with the potential to grow, thereby increasing the value of their investment. They do not expect to see an immediate return on their investment.

Most venture capitalists focus on certain types of businesses such as, start-ups, specific industries (health, technology, service) or technologies.

Advantages of Equity Financing
The major advantage of equity financing is that the cash flow that would have been used to repay the loan, can be used to grow the business.

Dis-Advantages of Equity Financing
The major dis-advantage of equity financing is the loss of interest of ownership of your business and also the possible loss of complete control that can accompany a sharing of business ownership with investors.

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