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The Main Differences Between Debt Financing and Equity Financing

The Main Differences Between Debt Financing and Equity Financing

There are two main types of finance available for businesses - debt financing and equity financing. Read on to find out the main differences between them.

7th January 2020
Reading Time: 3 minutes

Most companies use both debt financing and equity financing to support the everyday cost of running that business. There are some critical advantages and disadvantages to both, so it is essential that you are fully aware of both. Your decision will have to factor in these risks and benefits, as well as how accessible they are to you.

Debt financing

This type of financing means you are sourcing money from a lender, such as a bank or credit union. In some cases, a friend may even lend you money from their company, but in all cases it requires you to repay that amount at a later stage. There may or may not be interest rates associated with the repayments. The interest rates and how much they are depends on the loan or negotiation you achieve with the lender.

As the name itself states, it is ‘debt’ financing. Essentially, you are putting yourself in a position of debt in order to receive the funds you need now. The same way credit cards and home loans work.

Equity financing

In a nutshell, equity financing is money sourced from within the company, and therefore does not require to be repaid. This is clearly a favourable option for business owners, however not always viable if not totally available. It depends on the resources you have, so if you are a start up for example this may be especially difficult.

Once you are a well established business, or very successful and have plenty of in house resources, this is much easier and usually the option used by most businesses.

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Sources of financing

It’s very handy to know who you need to approach for each type of financing option. Below is a compiled list so you don’t have to do the running around.

Debt

One of the most common sources of debt financing is financial institutions. They come in the form of loans, overdrafts, equipment leases and asset financing. There are many options available beyond these examples, so for a thorough run down you should speak to your financial expert.

For most trade companies, they offer a credit account. This allows you to have the goods first, and delay payment of it according to their terms. This could be 7 days, 14 days or 30 days the month after the invoice date. This allows your business to breathe and worry about payment at a later date.

Family and friends are also commonly debt financiers, however this is more commonly called a debt finance arrangement. There are typically no contracts drawn up and signed since it’s an arrangement between friends or family. The main risk here is potentially ruining that relationship. Be sure to enter into an arrangement with someone very trustworthy.

Equity

Self-funding is simply providing the funds needed from your own personal finances. In most cases, lenders and investors will prefer that you have done some self funding before they decide to invest. This shows that you are serious about the business and will take it seriously.

You can also offer equity in your business in return for their investment. This is most commonly in the form of shares. However, the issue with this will be if you ever want to gain back control of your business. You will have to buy out their shares back from them in order to do so.

Venture capitalists are large scale investors who require large equity in return. They also offer industry knowledge and can really boost your financing immensely, but at a risk. If they gain control over your business, you will no longer be able to direct it in the way that you wish.

You can also float your business on the stock market. This allows the public to freely buy shares in your company. This is a very complex and expensive option though, so you will need to really consider what is best for your business.

Conclusion

As usual, the benefits and drawbacks to both debt financing and equity financing are quite even. The more you are able to receive, the more control you can potentially loose. The less complex the option, usually the less money you are able to finance too. Each option will be suitable for different types of business and business structures. Therefore, it is advised to consult an experienced finance lawyer who can advise you further.

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Author
Taeisha Dou

Taeisha is a Legal intern at Lawpath. She is a Law student at Macquarie University, previously completing her Commerce degree. She has an interest in Commercial Law.