There is a multitude of ways to fund a business. Two of the most common ones are debt financing and equity financing. But what are the differences between the two? What are their advantages and disadvantages? What does it matter to your business?

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For a business to operate, it has to have capital, especially working capital.   Capital is the term used when referring to the cash a company has on hand so it can function.  Working capital is the money used to cover a company’s short-term expenses, which are due within one year.  It is the difference between current assets and current liabilities. 

Most companies use working capital to purchase inventory, pay the short-term debt, and for day-to-day operating expenses.  Many companies utilize either debt or equity financing, or some combination of the two, to obtain capital to cover immediate funding needs while customer invoices are waiting to be paid.  Once the invoices are paid, the debt is retired and the cycle begins again.  In most cases, a company will establish a line of credit with a lender or have the lender create a credit facility that can be drawn upon, as defined by the needs of the business.

Rapid access to cash on a recurring basis can be extremely advantageous to a business as it works to cover short-term expenses and is an easier solution than negotiating a loan from the bank every month. This financing generally breaks down into two categories:

 

• Debt financing is capital obtained from a loan. There is an expectation that the borrower will need to repay the loan according to the lender’s terms, but the business owner doesn’t give up any portion of the ownership or control of the company to receive this capital.  Very often there is a collateral component to debt financing either in the form of inventory, accounts receivables/invoices, real estate, or business assets.1

• Equity financing comes from the funds obtained through a sale of a portion of the business’ equity to an investor. Equity financing is generally the type of funding provided to a company from venture capital or angel investors.  Unlike debt financing, there’s no expectation or obligation for the business owner to repay the investor for this purchase. Depending on the arrangements made during the investor’s acquisition of a percentage stake in the business, the investor may obtain partial (or even full) control of the business or the board of directors. 1

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Interest rates can vary from lender to lender and loan to loan.  Be sure to read the terms of your agreement and negotiate where you can to be sure the finance package you put together is mutually beneficial to you and the lender.  As interest rates rise and credit markets tighten, banks tend to lend less, so understanding the terms of your loan is extremely important. 

The most important part of the funding process is finding the right partner to help you meet the needs of your business.  The right lender will put together a package to meet your needs and be there as a partner to your company through both the good and lean times. 

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Reference

1. https://www.investopedia.com/ask/answers/042215/what-are-benefits-company-using-equity-financing-vs-debt-financing.asp