Most types of external finance fall into one of two categories: debt or equity. These are two very different methods of financing and there are pros and cons to each.
Many businesses choose to use a combination of the two. In this article we explain the terms debt and equity and take a look at some of the key differences in order to help you make the right decision when you’re raising finance for your company.
What is debt and equity?
What is equity finance?
Equity finance is the process of raising capital by selling shares in your business. There are various sources of equity finance, including angel investors, venture capitalists, private equity firms, and equity crowdfunding platforms. Some companies will raise several rounds of equity funding from different types of investors over the course of the business lifecycle.
Equity investors make a return on investment by eventually selling their shares or by receiving dividends (a share of the company’s profits - this is more common for mature companies). They have a vested interest in the success of the business, and the right investor will provide expertise and contacts to help the company grow.
You can find out more about equity finance in our blog post, What is equity finance and how does it work?
What is debt finance?
Whether you’ve taken out a mortgage, car or student loan, you’re probably already familiar with debt financing. It essentially involves borrowing a lump sum, which you then pay back over time plus an agreed-upon amount of interest.
Debt finance comes in various forms, including business loans, commercial mortgages, asset finance, and working capital facilities, for example overdrafts and invoice discounting. It can be secured against an asset you own, or unsecured. Due to the lower level of risk to the lender, secured debt is generally easier to obtain and cheaper.
What is the difference between debt financing and equity financing?
There are a number of key differences to bear in mind when you’re considering which of these funding methods to choose. These include:
With debt finance you’re required to repay the money plus interest over a set period of time, typically in monthly instalments. Equity finance, on the other hand, carries no repayment obligation, so more money can be channelled into growing your business.
Investors do, of course, want to make a return on their investment, but this only happens if and when your company does well. Therefore, unlike debt finance which has a pre-determined cost, the cost of equity finance is more variable, as it’s a share in the future earnings and value of your company.
Equity investors buy a stake in your business, meaning that your own shareholding decreases, whereas with debt finance you retain full ownership. However, it can be worth having a reduced percentage of the business if the equity investor provides a lot of value (in the form of both money and non-financial resources, such as expert guidance and access to contacts) that helps you to create a larger, more successful company. Think of it this way: would you rather own 100% of a £100k company or 70% of a £1 million company?
A lender may ask the borrower to pledge an asset as security for the loan, such as property or equipment. If the borrower can’t repay the loan, the lender may claim the asset to get their money back. With equity finance, however, you don’t need to put up collateral.
Access to finance
If you’re a start-up with no trading history or physical assets and you don’t want to use personal security, you might find it difficult to secure debt finance, at least from traditional lenders. Equity investors are often willing to back companies that are considered too high risk by a lot of debt finance providers.
An equity investor might ask for a board seat. That means they’ll have input into the overall direction of the business and will be involved in company decisions. The right investor will bring valuable experience and expertise to the boardroom and will be able to open doors for you with their network of contacts. By contrast, a lender has no ownership and therefore no involvement in business decisions.
If you’re in a hurry to raise cash for your business, then equity financing probably isn’t your best option. It can take a considerable amount of time to find the right investor, and then you have to negotiate the terms of the deal and facilitate the due diligence process, among other things. There’s also a lot more legal work involved. Debt finance is usually more straightforward and you can often receive the funds in a matter of a few weeks or even days from some providers.
Which should you choose: debt or equity?
Ultimately, the financing method you choose will depend on your individual situation, including the nature of your business and its stage of development.
Debt finance might be the best option for you if:
- You have consistent cash flow and a proven business model
- You’d prefer to remain the sole owner of your business
- You’d like a short-term relationship that ends once the loan is repaid
- It’s easier for you to manage cash flow and forecast expenses if you know in advance how much principal and interest you need to pay
And equity finance could be the best option if:
- You have a limited financial history or lack of collateral
- You don’t want the burden of regular loan repayments
- You have plans for growth, such as moving into new markets or expanding operations, that require a lot of capital (you can often raise greater amounts with equity)
- You would benefit from the skills and experience that an investor could bring
Remember that you don’t necessarily need to choose one or the other; you might decide that a mixture of equity and debt would suit your company best.
Debt to equity ratio
One thing to bear in mind, whether you’re looking for a loan or equity investment, is your debt to equity ratio. As the name suggests, this financial ratio compares the amount of debt relative to the amount of equity that is used to finance your company’s assets.
You can calculate your debt to equity ratio by dividing your total liabilities (what your business owes to others) by shareholders' equity (your total assets minus total liabilities).
It’s an important metric as potential lenders and investors may look at it as an indicator of the financial health of your business. The higher the debt to equity ratio, the riskier they usually consider the investment to be, as the company may not be able to repay its debts.
However, they may not want to invest in a business with a very low ratio, either, as this can mean that you haven’t efficiently grown your business by making use of debt.
So, what is a good debt to equity ratio? The answer largely depends on the industry your business is in. Companies that invest large sums of money into assets (capital intensive companies), for example in the manufacturing industry, often have a comparatively high debt to equity ratio. Businesses in, say, the service industries, tend to have a lower ratio.
Ultimately, successful businesses tend to use a mix of debt and equity appropriate for their industry, so this is something to keep in mind as you grow your company and raise finance.
If you would like to learn more about these forms of finance, please explore the content in this blog hub or get in touch with our friendly and knowledgeable team. We offer flexible business finance, both loans and equity, for companies in Wales from £1,000 up to £5 million.