Differences Between Debt and Equity Financing

As a business owner, you may wish to consider different ways of financing your operations or your expansion. Securing funding is usually divided into debt and equity financing. Debt generally refers to borrowed money you eventually repay, while equity refers to raising money by selling an interest in your business. Since equity and debt funding can be preferable in different situations, it is worth keeping in mind the options available to you when deciding how to finance your business. This article will explain some of the most common debt and equity financing methods. 

What is Debt Financing?

Put simply, debt financing is where you accept financing from an outside source and promise to repay the amount you have taken with interest. The loan money itself is often referred to as the principal, and you will tend to make reoccurring payments (usually monthly payments) towards the principal and the interest. 

You will often also give a type of security to the lender. Security is an asset you put up against the loan. This means that if you fail to make your principal and interest payments, the lender will be able to take your security. In this sense, security gives the lender confidence that they will get their money back. 

Types of Debt Financing

There are several different ways of organising your debt funding. For example, you could use a:

• traditional bank loan;
• bond;
• credit facility; or
• loan from family and friends.

Bank Loans

Various bank loan schemes assist small businesses in securing business loans for their operations. To secure a loan, you must:

• talk to a willing bank;
• provide security; and 
• often explain your business goals. 

Traditional bank loans have better interest rates than alternative lenders, so they are often an excellent place to start.

Bonds

Issuing bonds can also be a good alternative or addition to a bank loan. You will often pay a lower interest rate to bond investors than you would to a bank, which is essential as it can marginally increase your profits. 

Furthermore, traditional bank loans may come with conditions, such as a restriction on issuing more debt until the loan is paid back. On the other hand, bonds give the borrower much more freedom. As a result, many companies issue bonds to bring in a cash injection into the business.

Credit Facilities

Credit facilities can also give you access to cash. A revolving credit facility, for example, works similarly to an overdraft and can give you access to funds on short notice. This can be helpful if you encounter cash flow issues. 

What is Equity Financing?

On the other hand, equity financing is where you raise money by selling an interest in your business to an outside investor. By acquiring a share in your business, the investor will expect:

• dividend payments from future profits; and 
• voting rights in shareholder meetings and resolutions. 

This means that you will not have to repay a debt. Instead, you will share a portion of your profits with the investor. 

Types of Equity Financing

Some common ways of securing equity financing include:

• equity crowdfunding;
• investment from venture capitalists or angel investors;
• completing an initial public offering; and
• mezzanine financing.

Crowdfunding

Crowdfunding can be a good way of raising money in the early stages of your company. It involves selling shares to the public through unconventional channels like social media.

Venture Capitalists and Angel Investors 

Venture capitalists and angel investors can help you raise significant money while getting expertise from industry specialists. Angel investors tend to operate within a niche, investing only in one industry. Securing financing from this type of investor can bring expertise to the table. Nevertheless, you will be sacrificing a percentage of ownership in your company. 

Initial Public Offering

Similarly, if your business is ready for an initial public offering, you may be able to increase the value of your company and raise significant amounts of money. 

Mezzanine Financing 

Finally, mezzanine financing combines debt and equity. Consequently, it can be attractive if you are conscious of the debt-to-equity ratio in your balance sheet. 

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Key Takeaways

As a business looking to finance your operations or growth, you will want to consider the range of options available, including debt and equity financing. Debt financing involves taking money from an external source, which you pay back with interest. Standard methods include traditional bank loans, issuing bonds, and credit facilities. On the other hand, equity financing involves selling a share of your business to raise funds without debt. This involves securing an investment or completing an initial public offering.

If you need help understanding the difference between debt and equity finance, our experienced corporate lawyers can assist as part of our LegalVision membership. You will have unlimited access to lawyers to answer your questions and draft and review your documents for a low monthly fee. Call us today at 0808 196 8584 or visit our membership page.

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