Debt vs. Equity Financing

If you are a small business, one of the things you have to understand is financing. Money makes the world go round, the business world at least. Knowing the difference between debt and equity financing is a must. Let's take a look:

The first thing you have to understand as a small business is that choosing between debt and equity financing is up to you. It is a matter of personal preference, but will impact your control and indebtedness. Knowing what you can about the two will help you to make an informed decision. Whenever you look for financing, just remember that lenders want to see evidence your business will grow and provide a return on investment.

Debt financing is what is sounds like. It is where you get a loan (go into debt) for some financing. It is getting financing by borrowing money that is to be repaid over a period of time, with interest.

Debt financing can be either short-term, where the loan is to be paid in full within a year. Or it can be long term, which simply means the repayment term is over a year.

When you finance your small business with debt financing, you are not giving anyone ownership over your company. You borrow the money, and when you pay it back with interest, you are free of the debt, and your obligation is over.

Equity financing means that you get money, but the lender gets a share of your business in return. It allows you to not get into debt, but it means giving up some control of your company. You dilute your ownership. This is a great way to get money when you need it and can't pay it back, but the disadvantage is losing ownership.

Both debt and equity financing have an important place in the small business world. They provide opportunities for growth, and both have pros and cons. If your business should fail, if you used debt financing, you would still be responsible for the loan. With equity financing, both you and the investor would lose out, but you would not have to pay them back their investment.

There are also connotations attached to each type of financing. For example, those that choose too much equity financing may not be making the most productive use of their capital. In addition, if you have too much equity financing, and do not retain enough equity for yourself, it might suggest that you are not committed to your own business.

Debt financing is also risky, and often difficult to obtain, based on credit worthiness, debt to equity rations, etc. If you have cash flow problems, a lender might ask why you think you can take on extra debt, and if you do so, where you intend to get the capital to both repay the debt and continue to grow.

As you can see, there is a lot to consider when determine how your small business will obtain financing.