Debt vs Equity Financing: Difference? – Which Option is Best for You?

When a company wants to expand its work or reach, it requires funds or working capital, and accumulating such a tremendous amount of funds alone is not an easy task. So a company explores two ways of getting funds; debts or equity. Although debt and equity are two different ways to onboard funds for the company, both have their significance.

This article will discuss the two options that every entrepreneur has to face in their journey. In addition, we’ll also discuss the differences and objectives. Finally, we’ll conclude the article with a rational decision about the best option for entrepreneurs. So, let’s start with today’s article.

What are Financing and its Types?

In simple words, financing is providing funds for business activities, making purchases, or investing. Financial institutions like banks supply adequate funds to businesses, consumers, and investors to help them achieve their goals. Not just in business, financing is a highly effective process for every economic system, as it helps companies to purchase products out of their immediate reach. There are two types of financing; debt financing and equity financing.

1. Debt Financing

The borrower is obligated to repay the amount within a stipulated time and specified interest in this type of financing. Debt financing is commonly known as loans.

For example, you take 1,00,000 rupees debt from the public. Now, you must repay the loan you have taken from the public. Moreover, specific interest rates would also be levied on the overall debt financing.

2. Equity Financing

On the other hand, equity financing consists of giving up some part of the ownership in place of funds. Determining the ratio of funds and ownership comes from the valuation process.

For example, if a company has a valuation of 100cr. And its shares are divided into multiple fractions of 500 each; buyers can get 500 x (no. of shares) ownership in the company. In simple words, it is like giving up some part of a profit to get some funds.

What are the Merits of Equity and Debt Financing?

Merits of Equity Financing

The most significant merit of going with equity financing is that it doesn’t put you in the creditor-debitor relationship. The fund you are accumulating from the public remains with you as an asset, not a liability.

Hence, even if your business enters into bankruptcy, you need not worry about the repayment of the fund to investors.

Equity financing puts no extra financial burden on the company, helping it to focus on primary elements. Last but not least, companies tend to get more funds in equity financing than debt.

Merits of Debt Financing

Debt financing has numerous benefits. Foremost among them is that the lender doesn’t have any control over the company or its decisions, making the company run hassle-free with unity of direction.

Another benefit is that company gets tax relief on the interest paid on such loan or debt. Finally, it becomes easy for a company to track finances as interest is paid at a specific rate.

What are the Demerits of Equity and Debt Financing?

Demerits of Equity Financing

The biggest demerit is that one needs to give up a part of the company’s share to investors for equity financing. Another disadvantage could be the diversification of interest as the shareholders might have different opinions than you. Hence, you are always required to take suggestions or discuss things before deploying.

Demerits of Debt Financing

Unlike equity, debt financing requires a certain payout on a half-yearly or yearly basis. Therefore, it could be overwhelming for the company if it’s under any financial burden. Lastly, debt financing creates obligations on the company.

Debt vs. Equity: Which One is Better for Entrepreneurs?

We have discussed some crucial fundamentals and objectives of debt and equity financing. But the question arises which among these two is better for entrepreneurs? Let’s dive deeper into some questions to answer whether you should go with equity or debt.

Do you urgently need money?

If your startup or company requires urgent funds, dealing in equity financing could not be the best choice as investors take a lot of time deciding and closing the best deal. Hence, debt financing could be better for those who require speed or urgent money as it moves faster.

How much money do you require or want?

The required amount of money decides whether to go for debt or equity. For instance, if someone needs 100,000 INR, he can take that money using a credit card if all options fail.

But, at the same time, someone who needs 100,000,000 INR has fewer options available, including equity funding.

Do you need more than just cash?

If you need only cash, choosing either option will help. However, if you want someone’s expertise or mentorship on a specific project, going with equity financing would be a good decision.

For example, Shark Tank has judges who hold expertise in their respective fields. Entrepreneurs come to pitch their ideas and get deals based on their idea, presentation, and the amount of value a person could add while being with the company or startup.

Are you comfortable sharing everything?

Equity financing means giving ownership to your investors. Once investors get the ownership, disclosing every critical decision would be mandatory.

However, if you don’t feel comfortable doing that, choosing debt can be a better option as it doesn’t create any obligation to disclose facts about debtors.

Conclusion

Although it might look challenging to choose from equity or debt financing, it’s not that big. We have shared with you a complete analysis of the meanings, merits, demerits, and evaluation processes so that you can pick the best financing method for your business. Moreover, the bottom line is that whether you choose debt or equity financing, make sure you utilize it with the primary aim of solving the problem in your startup or company.

Don’t take debt even if you are ready to shed some part of your company. Similarly, don’t go with equity financing if you aren’t comfortable sharing your business with others. Again, though, it’s always better to take others’ expertise and guidance for some part of sharing. If you are on board an experienced investor, he will put his inputs to project business in a better position. Regardless, he might demand a good portion of the company.

In addition, we have also curated a list of frequently asked questions for those who want quick answers to their questions. Kindly go through them and share your doubts in the comment section. Also, don’t forget to follow us on our social media handles.

Frequently Asked Questions

What is the difference between debt and equity?

In simple sentences, debt is a cheap source of financing since it helps entrepreneurs save a lot of taxes. On the other hand, equity is comparatively a convenient method of financing for businesses that don’t have collateral.

Also, debt holders get a pre-determined interest rate over their principal amount.

Which company can use equity financing?

Sole proprietorships are the easiest businesses to form, but equity financing is limited to the owner’s assets. General partnerships need a minimum of two owners, so equity financing possibilities are more significant than in proprietorships.

How do small businesses get equity financing?

There are two significant ways small businesses can utilize equity financing: the first is a private placement of stock with investors, and the second is venture capital firms and public stock offerings.

However, private placement is more straightforward and typical for young companies or startup firms.

What is a debt-to-equity ratio?

This ratio concerns the company’s financial position based on debt financing and equity financing. In simple words, it shows the proportion of diversification of debts and equities in a company.

For instance, a company has a valuation of 100,000 INR; it has 40,000 through debt financing and the rest 60,000 through equity financing. Hence, its debt-to-equity ratio would be 4:6