When to Choose Between Debt and Equity Financing

Debt and equity financing both give you the funds to grow your business, but in different ways. If you like to be in control and make the decisions, debt equity like a small business loan from a lender is better than equity financing because you call the shots. When you are going into an uncertain or competitive market, equity financing gives you access to advisors and strategists, making complicated situations easier to handle, while debt financing means you’re on your own.

Making the right choice comes down to your unique business situation. Sometimes it’s better to take on higher expenses and lower cash flow while keeping all of your business’s future profits (with debt financing), and sometimes you might prefer to give up future profits to lower your personal risk (with equity financing).

Here’s a cheat sheet with the differences between debt and equity financing. Then we’ll go into examples based on the types of lenders and specific situations you may find yourself in.

When to Choose Debt Financing Over Equity

Purchasing equipment

Debt financing is better than equity financing when your factory needs upgraded equipment or you need to replace aging trucks. With debt financing, you make the decisions vs. having to clear the purchases with investors that are not in the day-to-day operations. You can maintain ownership of the company rather than give shares away by taking a small business loan designed for your specific needs, like a manufacturing business loan or commercial fleet financing plan.

For debt lenders, the equipment you buy works as collateral for the loan, so you may not have to worry about personal guarantees. Plus, you get to write off the loan interest, allowing you to pay less in taxes. Further, with debt financing, you don’t have to spend time convincing investors of the “why” behind your business decisions, saving you time and stress.

Stocking up on inventory for the busy season

Short-term debt financing like an inventory financing loan is better than equity financing in this case because you don’t give away a share of your future profits to simply secure stock. And you can boost that profit by writing off the loan’s interest.

You may also consider using short-term debt financing like working capital loans to hire seasonal staff. With debt financing like this, you control business decisions and don’t have to worry about equity investors weighing in on hiring or firing. After all, you know your business’s needs and how much staff is required to meet your goals; you don’t have to justify decisions to third parties when you choose debt over equity financing.

Loans from traditional and alternative lenders make sense in this situation, but alternative financing may be extra helpful when you need funding fast, as there is usually less red tape in the process.

A perfect example is if you’re a fashion retailer chasing inventory for the hottest items of the season and manufacturers are closing orders and wholesalers are selling out. If traditional debt financing is going to be too slow, an alternative lender may offer a faster process. Also, equity financing through a private investor could help you seize the opportunity if you’re willing to sacrifice some control of the business.

Maintaining full control over long-term growth decisions

Equity investors normally want a say in management’s day-to-day, but you keep full control with debt financing like business term loans, which are great for long-term investments like buying a new location for your franchise. Debt lenders will have a claim to the property in case of default, making it similar to equity financing, but they have no say if you want to sell the location you bought after 10 years.

Equity investors, on the other hand, might argue or even try to block your decision, derailing your long-term goals. By choosing debt financing over equity, if you decide to sell your business, you only have to repay your lenders vs. negotiating the shares and sale with your investors.

While both traditional banks and alternative lenders can meet your needs here, the larger and more established lenders may be more willing to approve big loans or longer loan terms, like for large real estate purchases or acquiring another company. Private credit firms can also be worth a look since they have access to debt financing from hedge funds, asset managers, and private investment groups.

When to Choose Equity Financing Over Debt

Sharing the risks when entering new markets

Equity financing is preferable over debt when you want to share risks with other investors, like when you enter new and unproven markets. Debt puts all the risk on your shoulders, and while equity investors will take a share of the profits, they would also have to share in any losses.

You have multiple options when choosing equity over debt lenders depending on the size and age of your business. Angel investors are perfect if you are an early-stage start-up, or you may consider venture capital firms if you already have a successful product in the market. Friends and family can also be good equity investment partners, especially if you are just starting out.

When you won’t have short-term cash flow

You should also choose equity over debt when you don’t have near-term cash flow since debt lenders will want you to start paying down the principal and making interest payments immediately, but equity investors will wait to get paid out of future profits. This can be especially important if you’re using the funds to invest in something like a remodel of your restaurant, where you won’t be serving any food or generating revenue until you reopen.

In addition to the investors mentioned in the previous section, you could also look into private equity firms. They might not have the sky-high expectations that early investors do, but they also might not have the same long-term horizon as an angel investor or venture capital firm. And though you might have heard the term “private equity“ mostly associated with financial news and large companies, there are plenty of private equity firms out there that work with small and medium-sized businesses, making equity financing obtainable just like debt financing from smaller banks and alternative lenders.

When you’re starting a business or don’t have a great track record

Equity will be better than debt when you have a great idea but don’t have the money to execute it. This is because equity investors are more willing to take a risk on a good idea, while traditional lenders may not be willing to support unproven businesses. It can also depend on the person you talk to and where their experience lies.

When you choose equity, you should speak with investors who know your space. This can be true whether you’re a start-up with just a good idea or you’ve been in a business for a while but haven’t turned a substantial profit. Equity investors will look at your vision and your execution so far and evaluate the situation in full context while deciding if you’re worth the risk, but debt lenders will focus only on your ability to repay.

Equity investors may also have the experience to determine your company’s inefficiencies and bring a person from their network to resolve them, making you profitable, while a debt financing lender may only look at the numbers.

If you’re just starting out, angel investors or friends and family are the best places to start. But if you have been in business for a while and you’re more of a visionary, venture or private equity investors could be better as they sometimes supply their own teams that dive into the management of the business with you.

Getting access to expertise and networks

When you need access to professionals and consultants, equity financing is better over debt financing because equity investors make introductions to their networks of customers, distributors, and consultants. When working with debt lenders, you need to determine the right vendors to approach alone, and this is where funds can be depleted fast.

The right equity investor can accelerate your business growth, and even though you have to share the profits, you might still be better off if you’re getting a smaller piece of a much larger pie. Here again, the various equity investor types could all work. It’s just a matter of matching your business with the right expertise and network.

And those are the differences between debt and equity financing and when to choose which option based on your goals and specific situation.