Is debt or equity funding the right choice for startups? 

As startup founders, one of the most important decisions you will have to make is – how to raise capital for your business. Irrespective of whether you're planning to launch an upcoming venture or expand your current business operations, you require funding. 

As an entrepreneur, you have two main options for raising the required funding – equity financing and debt financing. Both these types of financing offer funding for a startup, but which is the right option for you? 

In this guide, we break down the differences between these two options. We also take a look at how each method works, discuss the pros and cons, helping you choose the right choice that best suits your needs.

Let’s get started. 

What is debt financing? 

In debt financing, a lender offers you the required capital for your business. You repay the borrowed amount over time, along with interest. You can avail of debt financing from banks, NBFCs, digital lenders or even friends and family. The lender considers several factors like:

  • Credit scores of the business and personal

  • Annual turnover of your business

  • Business operation time 

  • And more

These factors decide whether you are eligible to receive a business loan, the amount you qualify for, the interest charged and other terms of the loan. Once you have repaid the loan amount in full, principal cum interest, there are no additional obligations.

Some of the common types of debt financing include:

  • Short-term and long-term business loans 

  • Lines of Credit

  • Merchant Cash Advance 

  • Invoice Financing 

  • Business credit cards

Pros and Cons of Debt Financing 

While debt financing has its advantages, there are certain drawbacks as well. Here, we take a closer look at the pros and cons of this type of funding.

Pros:

  • You retain complete control over your business: In debt financing, you borrow money from the lender under specified terms and conditions. The lender does not have any say in how you run your business. It means your ownership is not diluted, and you don't have to share profits with the lender in the long-run. Your obligation to the lender is over when you repay the borrowed amount in full.  

  • Wide Range of Options: As one of the most common types of business funding, you have plenty of options to choose from – flexible lines of credit, instant business loans, secured long-term loans, etc. 

  • Repayments are fixed: With debt financing, you have to pay pre-decided monthly EMIs to the lender. The EMIs remain the same month-after-month. So, you know when to pay, how much to pay, and how long you will be paying and so on. This way, you can plan your monthly business finances ahead. 

  • Tax Benefits: Some types of debt funding, like business loans, help you avail tax benefits by claiming deductions on the IT returns of your company.  

  • Readily Available: As the most common type of business funding, debt financing is readily available for businesses of all sizes and across industries. You can choose from different kinds of lenders – banks, NBFCs, online lenders, etc.  

Cons:

  • High-interest rates and other fees: All borrowers have to pay interest on the principal amount. Besides interest, there are additional fees to be paid, including transaction fees, loan processing charges and more. If your business has a poor credit score, then you are considered a risky borrower, which means you face even higher interest rates.  

  • Increases your DTI ratio: When you opt for debt financing, you increase the DTI ratio of your business. It can depict your business in a poor light to investors and stakeholders.  

  • Risk of Defaulting: If something unexpected were to happen to your business, and you are unable to repay the loan, it can lead to your collaterals being possessed by the lender. 

  • Negatively impact your Credit Scores: If your business falls upon hard times and you miss a monthly payment, it reflects poorly on your credit history, impacting your credit scores.  

  • Stringent Eligibility Requirements: Different borrowers have different eligibility terms and conditions. If you are a new business without adequate collateral or poor credit scores, then you may have a hard time qualifying for debt financing. 

  • Does not offer Business Guidance: When you borrow a loan from a lender, you receive only the lump sum amount. The lender does not provide you any further business guidance or consulting as in equity financing.  

This brings us to the next option – Equity Financing. 

What is Equity Financing? 

In equity financing, a business receives capital from an investor. However, instead of repaying the borrowed amount in the form of EMIs, the borrower offers a percentage of ownership in the business to the investor. 

Equity financing works differently compared to traditional debt financing. Here, instead of approaching a lender, you approach an investor. The investor provides you with the capital in exchange for shares in your company. The investor becomes a stakeholder in your business.

There are no monthly EMIs to repay the lender. However, you have to share a percentage of your business profits with the investor. Additionally, the investor also enjoys certain rights within your company like – a seat on the board, voting rights and more.

Some of the common types of equity financing include:

  • Venture Capitalists

  • Angel Investors

  • Equity Funding from friends and family 

  • Mezzanine Funding 

  • Crowdfunding 

Additional Reading: Six Popular Types of Equity Financing to Raise Capital for your Small Business

Pros and Cons of Equity Funding  

Just like debt funding, equity financing has benefits as well as drawbacks. Let’s take a closer look at the pros and cons to decide if this is the right financing option for your business. 

Pros:

  • Risk is borne by the investor: With equity financing, the risks fall on the investor. Since you don’t submit any collateral, your business doesn’t have any risk. Investors see a return of their investment, only when your business is profitable. 

  • Easier to Avail: If you're a new business with zero credit history and no collateral, debt funding may be out of your reach. Even when you qualify for debt funding, the lender may offer you less-than-desirable terms and high-interest rates. Equity financing, on the other hand, is an excellent option for startups since there is no need to provide credit score or collateral.  

  • It doesn’t impact your Credit Score: As a startup, you are looking to build your credit history. Debt financing can negatively impact your credit score, bringing it further down. Equity financing, on the other hand, does not affect your credit score.  

  • No Interest and Other Fees: With equity financing, you don’t have to worry about paying interest or fees on the amount you borrowed. This increases the cash flow of your business, as the entire lump sum invested is available for your business operations. 

  • More than Capital: It’s one of the biggest benefits of equity financing for startups. As a startup, when you opt for equity financing, the investor brings more than capital. The investor offers you industry insight, helps to build your network connections and gain experience. 

Cons:

  • You give up a part of the ownership of the Business: With equity financing, you lose complete control of the business. Not only does equity financing reduce your share of profits, but you also give up the power to make decisions to outside investors. 

  • Finding the right investors is a Major Challenge: Finding the right investors who understand your business and agree with your visions is a time-consuming process. 

EndNote

Which is the Right Option for Startups? 

There's no one answer. It all depends on the nature of your business, what you're looking for from the investment and more. If you're still on the finance, consider these factors to help you decide the right financing option for your startup.

Choose Equity Financing for your Startup if:

  • Your company has the potential to scale up and grow profitable in a short time

  • You require substantial financing that is not available with debt financing

  • You are looking for an investor to offer you some guidance, industry connections, experience

  • You don’t have collateral or adequate credit scores to qualify for traditional debt financing 

  • Your capital needs aren’t immediate 

Opt for Debt Financing for your Startup if:

  • You have smaller, immediate capital needs 

  • You don’t want to share ownership of your business with others 

  • You’re willing to repay the borrowed amount with interest

As you can see, both debt and equity financing serve different purposes. Make sure to compare the pros and cons of both, and choose the right option that best suits your startup.