Debt Financing: How Is It Different from Equity Financing?
December 15th, 2022 · 5 min read
There are multiple ways to finance a new business venture or fuel growth for an existing one. In most cases, businesses will outsource funds outside their own capital reserves. Even if they have enough cash on hand, they may not want to deplete their funds in an emergency. In these cases, businesses searching for substantial funding may opt for debt or equity financing.
Both forms of financing are designed to provide money for businesses, but how this capital is generated and repaid varies. Here’s what you need to know about debt financing.
What Is Debt Financing?
Debt financing is the act of raising funds through issuing debt instruments, such as bonds or loans. Companies needing capital will solicit investors to purchase these debt instruments in exchange for a set return within an agreed-upon timeframe. This return can come in the form of periodic interest payments or repayment of principal at maturity — usually both. It’s important to remember that debt financing requires repayment of the principal and interest regardless of the business’ performance.
Difference Between Debt and Equity Financing
Debt financing is often compared to equity financing, which involves issuing stock or common shares in exchange for capital. While both forms of financing can be beneficial for businesses, there are some key differences between the two.
Debt financing is typically less expensive than equity financing, as it involves the repayment of funds plus interest. However, debt holders don’t have any ownership rights to the company and are not affected by dividends or other corporate decisions. On the other hand, equity holders have ownership rights in the business and may receive dividends if profits allow.
In addition, debt is considered a lower-risk option for businesses than equity financing. Debt holders are only entitled to repayment of the principal amount and interest, regardless of the company’s performance. Equity holders, however, take on more risk as their return depends largely on the business’s success.
While both forms of financing can be advantageous for businesses, it’s important to understand the nuances between debt and equity financing — and make a decision based on your business needs.
Benefits of Debt Financing
Debt financing can provide several advantages to businesses in need of capital. Here are some of the key benefits of debt financing:
1. Tax advantages
Interest payments made on debt financing are usually tax-deductible, unlike most equity investments. Regardless of whether there are charges, line of credit or working capital accounts, the interest payments made on the debt can be deducted from taxes. Under Chapter 4 of Publication 535, the IRS rules that the business can “generally deduct as a business expense all interest you pay or accrue during the tax year on debts related to your trade or business”. It can be a great way to lower the overall tax burden for businesses.
2. Lower cost of capital
Unlike equity financing, debt holders are only entitled to the repayment of the principal plus interest — making it a much less expensive option for businesses. As long as the business can meet its obligations and pay back the loan on time, debt financing can be a cheaper way to access funds than equity financing.
3. 100% business ownership
One of the biggest advantages of debt financing is that it allows businesses to maintain full ownership. Since debt holders don’t have any claims on the business, they cannot influence any corporate decisions or receive dividends. However, equipment and machinery, vehicle, or very liquid accounts receivable may be collateral to secure the loan. In cases where the business fails to honor or defaults on its obligation to repay the loan, the lender may have the right to seize the collateral.
When using debt financing, businesses can often access various financing options depending on their current needs and creditworthiness. Businesses can choose from short-term or long-term loans, lines of credit, and even crowdfunding platforms. This allows businesses to tailor the financing to their specific needs rather than relying on equity investors who may have different expectations.
5. Accessible to all-size businesses
Start-ups and Small and Medium Businesses (SMBs) often have difficulty raising funds. First, you must convince potential venture capital investors that you have a viable business model. Then you must offer equity in your business, which can be difficult for founders and early-stage businesses. With debt financing, SMBs can access funds without giving away equity or convincing potential investors of their viability. Many lenders now offer debt financing specifically tailored to SMBs and start-ups.
Drawbacks of Debt Financing
As with any form of financing, there are certain drawbacks associated with debt financing. Before proceeding with debt financing, it’s important to consider the following disadvantages.
1. Requires Repayment
One of the biggest drawbacks of debt financing is that it requires repayment, usually with interest. This means businesses must be able to generate enough revenue to accommodate their loan payments. Furthermore, if the business encounters financial difficulties or enters a recession, it may find itself unable to meet its obligations — putting them in danger of defaulting on the loan.
2. Tends to Increase Debt
Debt financing tends to increase the overall amount of debt a business has. This can be detrimental if it causes the business to have too much debt, making them unable to access additional funding in the future or leading to bankruptcy. As such, businesses must carefully consider their borrowing capacity and be wary of taking on too much debt.
Is Debt Financing Right for Your Business?
When considering financing options, it’s important to do your research and ensure you understand each option’s implications. While debt financing can provide businesses with fast access to capital and low costs of capital, it also carries certain risks and obligations that must be taken into consideration. To determine if debt financing is the right choice, assess how much capital you need, consider your repayment capabilities, and be mindful of the risks associated with too much debt.
Ultimately, every business is different, and the right financing option will depend on their needs and goals. Weighing the pros and cons can help you to make an informed decision that’s best for your business.
Partner With Terrydale Capital for Your Debt Financing Needs
It’s important to understand when to seek debt financing, how it works, and when to seek debt financing. Terrydale Capital offers you a wide selection of commercial loan solution for your business. We work with you to tailor a plan that meets your needs and objectives — without taking away equity in your business or forcing you into an unsuitable repayment schedule. Our experts are here to help you understand all available options and to provide the best financing solution for your business. Contact us today to learn how we can help you grow your business with debt financing.
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