Equity Financing vs. Debt Financing: What are the benefits and disadvantages?

What we'll cover:

Overview

When your company raises capital, there are a few options that fall under the buckets of equity financing and debt financing. Many companies use a combination of both of these, but it’s important to note the advantages and disadvantages of each of these financing types. 

What is equity financing?

Equity financing happens through a priced round where a portion of the company’s equity is sold at a set price. For example, an owner gives up 10% of their company and sells it to an investor in return for capital. That investor now owns 10% of the company, and depending on the terms, may have input in business decisions moving forward.  

What are the benefits of equity financing?

There are many advantages of equity financing, including: 

1. There is no obligation to repay the money 
2. There are no additional financial burdens on the company – since there are no required monthly payments the company has more capital available to invest in growing their business. 
3. You’ll most likely partner with investors who can provide valuable consultation to help grow your business

What are the disadvantages of equity financing? 

While there are benefits to equity financing, there are also disadvantages you should be aware of, including:

1. In order to gain capital, you have to give investors a percentage of your company
2. This means you have to share information and consult with investors as new partners whenever you make decisions that affect the company 
3. To remove investors you’ll need to buy them out, which will most likely be more expensive than the capital they originally invested 

What is debt financing? 

Debt financing refers to borrowing money and then paying it back, most likely with interest. Most commonly, this is in the form of a loan, although there are some other types of debt financing. Debt financing may come with restrictions on your company’s activities. If your company needs to access additional debt financing in the future, it’s important to note that creditors look favorably on a low debt-to-equity ratio.

What are the benefits of debt financing?

Like equity financing, there are a few advantages of debt financing that include:

1. Usually the lender has no control over your business. Once you pay the loan back, your relationship with the lender ends. 
2. The interest you pay is tax-deductible. 
3. It’s easy to forecast expenses because loan payments are predictable.

What are the disadvantages of debt financing?

There are also disadvantages you should be aware of:

1. Debt needs to be paid back – so this can be risky as it’s a bet on your future ability to pay back the loan
2. You most likely will need to pay expenses on a regular schedule, which can create a financial burden as you grow your company 
3. Even if you’re an incorporated company, you may be asked to guarantee the loan with your personal financial assets.

Is debt financing cheaper than equity financing?

Depending on how well your company performs, debt can be cheaper than equity, but the opposite is also true. If you’re unable to turn a profit and you close, then equity financing costs you nothing.

If you take out a loan via debt financing and make no profit, you’re still responsible for paying back the loan plus interest. In this scenario, debt financing costs more. However, if you are successful and sell your company for millions, if you’ve given up equity, you’ll need to split that profit with shareholders. 

Are SAFE Notes and Convertible Notes debt or equity financing?

Created by Y Combinator, the simple agreement for future equity (SAFE) is a common equity funding document. The SAFE is a simple agreement that grants investors the right to purchase equity in the company at a future date. This allows the company and investors to delay the negotiation of company valuation and terms of investment until a later equity funding event.

A convertible note is a type of debt financing that provides a loan with interest with the expectation it will convert to equity. The investor will need to receive a balloon payment on a specified date or be allowed to convert the note to shares during a future equity funding event. Also, the notes generally provide a discount on the share purchase price paid by the future investors.

How to make the equity financing process cheaper and quicker 

Many companies find going through a priced round to be a slower, more costly process because of the back and forth of negotiating terms and high legal costs that are expected to be paid by the company.

Therefore, early-stage companies tend to gravitate towards SAFEs because they are simpler and quicker. However, when markets fluctuate, investors may become more conservative and prefer a priced round over a SAFE. 

We’ve made the equity financing process simpler with our Automated Equity Financing. Now you can close in as little as 14 days and save money on legal fees because attorneys will be focused on the important parts of the deal and not templated documents. Learn more about how it could help your company through your next round.