Debt vs. Equity Financing for Small Businesses: What's the Difference?

Debt and equity financing are two ways to secure funding when starting or growing a business. Debt financing is a loan, while equity financing comes from investors. Each works differently and has its own advantages and disadvantages. Understanding how they compare can help you decide which option may be more appropriate for meeting the capital needs of your business.

What Is Debt Financing?

Debt financing refers to borrowing money for your business. The money you borrow must be paid back, typically with interest. Depending on the type of debt financing involved, you may have a set time frame for repaying what you borrow.

Small business debt financing can take many different forms, including:

Personal loans that you use for your business – whether you borrow from a bank, credit union, online lender, or friends and family – would also fall into the debt financing category.

Debt financing can be distinguished based on its purpose and the need it helps to fill for small businesses.

Merchant cash advances and invoice loans, for example, are two types of short-term debt financing. Businesses borrow a set amount of money that is then repaid over a period of months, rather than years. This type of financing is usually appropriate for filling temporary cash flow gaps to cover working capital expenses.

An equipment loan, on the other hand, would typically be repaid over several years. Instead of being used to fund short-term needs, this type of loan is designed to help businesses invest in long-term growth goals.

What Is Equity Financing?

With equity financing, funding for the business comes from one or more investors. Those can be individual angel investors or venture capitalists. Angel investors take their private capital and invest it into startups and growing businesses. Venture capitalists also invest in new businesses, but the difference is they're usually not investing their own money. Instead, the money that's used to invest may come from endowments or corporations.

Whether a business gets equity funding from an angel investor or venture capital firm, the common denominator is that business is typically handing over an ownership stake in exchange for capital. Assuming the business is successful, the angel investors or venture capitalists who invested would also claim a share of the business profits.

Debt Financing Pros and Cons

Debt financing can offer several advantages for small business borrowers, starting with speed.

"Debt financing is a great way for a business to fund working capital quickly," says Chane Steiner, CEO of personal finance blog Crediful. "If done right, it can help grow your organization fast enough to repay the principal and interest of the loan, plus create a sizable profit."

With an online lender, for instance, you can get approved for debt financing and receive the loan proceeds in just a few business days. That's helpful if you need to cover working capital costs or there's a growth opportunity that requires you to move quickly.

Debt financing can also offer predictability if you have a loan or line of credit with a fixed payment schedule and fixed interest rate, says Paul T. Joseph, certified public accountant and founder of Joseph & Joseph Tax & Payroll in Michigan. As an added bonus, the interest on loan payments is typically tax-deductible, which can reduce your business's tax liability.

But perhaps the most important feature of debt financing is not sacrificing ownership and control of your business. Equity financing doesn't afford that same benefit.

On the list of downsides: Your business is required to repay debt financing, even if the business isn't doing well. Defaulting on a business loan could wreak havoc with your business and personal credit scores. If you pledged collateral for the loan, the lender could take possession of it to satisfy the debt. When there's a personal guarantee in place of collateral, the lender can come after your personal assets, such as your bank account or home, to collect what's owed.

While the lender is taking a risk on your business, you're also assuming some risk. If your business experiences a temporary dry spell or a longer downturn, that could put your business and personal financial health in jeopardy.

Equity Financing Pros and Cons

Compared with debt financing, equity financing doesn't carry the same pressures on cash flow, since you're not responsible for making monthly loan payments. Seeking out equity financing might also be appealing for startups and newer businesses that need larger funding amounts and are having trouble getting approved for loans.

There's also less direct risk to your business, in terms of loss of collateral or personal assets. If the business goes under, for instance, you don't have to repay your investors.

"By using equity financing, you're able to shift the risk to the investors based on the capital they have invested in the company," Joseph says. "This long-term approach allows you to conserve your revenues for investment into the company to grow your business."

Rather than using your profits to pay off a debt, you can invest it elsewhere and continue scaling. But that can come at a cost because you're not able to keep all those profits for yourself.

Steiner says, "Success is its own drawback with equity financing, since selling off part of a business that later becomes very profitable can be a lot more expensive than taking out a loan in the first place. For example, if you sell off a third of your company for a $10,000 investment and that business is later worth $10 million, then you've effectively lost several million."

When you give up a portion of your ownership in the company, you're also giving up a portion of your control in how it's run. Your investors may want to exercise voting rights, for instance, or have a say in key decisions.

If you have an investor on your side who's committed to your business's vision and overall success, that may not be a bad thing. But it could lead to conflict if your personalities don't mesh well or if the investor is suggesting changes that are counter to what you want to achieve in the business.

How to Choose Between Debt and Equity Financing for Your Small Business

Whether it makes more sense to use debt financing or equity financing to fund your business depends on several factors. As you weigh both options, consider these questions:

Steiner says your decision may ultimately depend on your timeline and how much funding you need.

"If you're fairly certain that an influx of cash will translate directly to increased profits in the short term, then a loan is the more sensible option," he says. "However, if your goals are more experimental and long term, or if your cash requirements are very great compared with your current revenue, then seeking investors is probably wise."