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Debt vs equity funding

When you want to grow your business, you may want to look at external sources for finance. At this point, you have a choice of taking on debt or raising capital through the sale of equity.

Debt versus equity? To choose which option is best for you, you would need to compare different things. You would need to look at the expected risk and return for your investor, and the costs and benefits for your business.

Debt finance

Does your business need funding to grow? Investment is tricky and often confusing. Watch our video with finance expert, Gary Torbett, as he helps you weigh up whether to use debt or equity funding.

Debt comes in many forms but generally involves borrowing a sum of money, which is often secured against a tangible asset. The debt is repaid with interest at an agreed future date.

Ideally your business should have a financial track record to secure debt.

You also need be able to demonstrate that you can repay the money borrowed.

Advantages of debt funding for a business

Debt is often a cost-efficient way of getting the finance you need for the short to medium term.

The cost of utilising debt depends on the interest rate and the length of the loan (plus any arrangement fees that some lenders charge).

Debt financing will be a finite and calculable cost for you and your business.

The cost to your business is the interest and arrangement fees along with any ancillary charges such as legal fees or valuation fees.

After you've paid the interest and repaid the principal, the debt financing will no longer cost your business money. This is a key difference from equity funding.

Equity investors generally have an ongoing say in how your business is run. You'll need to make your repayments on time and keep all terms and conditions.

Debt providers will only intervene if you fail to make agreed payments of capital or interest, or breach any terms and conditions. Such terms and conditions are often referred to as covenants.

There are many kinds of debt funding products available. These include:

  • Term loans
  • Invoice discounting
  • Asset finance

Equity funding

Equity funding is generally the issue of new shares in exchange for a cash investment. Your business receives the money it needs and the investor will own a share in your company. This means the investor will benefit from the success of your business.

Benefits may include proceeds from an eventual sale or buyout, and any dividends your business decides to pay before that happens.

Advantages of equity for a business

If your business doesn't have the revenues or financial history necessary to successfully apply for a business loan, your other option is equity funding. If your business needs money to grow, equity investors could provide it. They would understand that their return on their investment will come much later on. This type of funding may suit your business if it's at the early stages.

Equity investors benefit from your business by receiving dividends and/or when they exit your business. This means you won't have to worry about making regular repayments. Not having to think about making repayments while your business establishes itself can be helpful and it also helps manage your cash flow.

In most cases your business will have reasonable freedom to choose how to spend the investment in line with your business model.

The right equity investor should bring to your business more than just their money. Many will be well-connected through their previous investments or experience, and you can use their skills and experience to help grow your business.

Picking one funding option over the other

Why choose debt?

  • If you have revenue
  • Don't want to sell part of your business, and
  • Want a straightforward repayment programme with a simple cost structure

Why choose equity funding?

  • If you have little or no revenue
  • Want to bring on board additional expertise, and
  • Are happy to trade-off selling a stake in the company with potentially higher costs in order to achieve quicker and greater growth

For some businesses, the choice between equity and debt will be straightforward. For others, there will be elements of both that will be appealing and suitable. This means you may want to use one of the following types of financing.

Convertible debt

Convertible debt is also known as convertible bonds or convertible notes. It's a type of bond that companies can issue to investors. You would need to pay interest on the bond like a loan. However, the lender can choose to have the value of the loan repaid in cash or shares.

If the value of your company has gone up, your lender will want to be paid in shares. If the value has gone down, your lender will want to be paid in cash. Because your lender may benefit more from investing in your business, you might pay lower interest rates.

Equity and debt

It's not uncommon for an investor to fund a company through debt and equity at the same time. For example, you may want to bring on board an investor but limit how much of your company is sold to that investor.

If you're thinking about this kind of arrangement, make sure that it benefits your business as well as your potential investors.

Got a question about accessing finance?

Get in touch with our team of experienced financial readiness experts who can help you secure funding from a range of sources including bank funding, equity funding, and grants.

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