Equity finance versus debt finance
Finance & Funding
Key learnings
- Securing finance from a third party always involves cost but is worth doing if it will take your business to the next level.
- Debt finance is a form of loan that needs to be repaid while equity financing is selling shares in your company to investors.
- What’s best for your business depends on your current cashflow, stage of business and growth potential.
For a start-up or a growing business, getting the right funding at the right time can be a real lifeline. But taking the wrong funding can be a millstone around your neck. So, how do you decide what sort of funding is best for you? Here, we look at one of the most common decisions a business owner seeking funding needs to make: debt finance or equity finance?
Businesses tend to need additional finance for three reasons – starting a business, running one and growing one.
Start – new businesses/start-ups tend to have difficulty accessing finance as lenders feel there is more risk attached to new businesses usually due to their lack of customers and the lack of business assets.
Run – some businesses may need to raise finance to help cover day-to-day costs if they have a cashflow issue with a late payment or a lull in work to pay staff wages and suppliers on time.
Grow – businesses looking to expand need funds to take on new staff, create new product lines and deliver new services.
Internal sources of finance are funds found inside the business. For example, profits can be kept back to provide additional financing.
It’s important to look at your current cash balances and short-term investments and consider how much will be needed to support existing operations.
If there’s a surplus, then this is the most obvious source of finance for a new project.
If there’s no surplus, businesses should consider their future cashflow, but if this is not sufficient, then it’s worth considering debt finance or equity finance.
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What is debt finance?
Simply put, debt finance is a form of loan that is to be paid back over either a short or long period of time, usually with interest.
It’s a good option for businesses who don’t want to part with shares in the company in exchange for funding.
Some things to consider when taking on debt finance are:
- The term of the loan - this will dictate how much interest is charged and the amount of money you pay back. For example, a 12-month term will mean you pay little interest, but will probably attract a large outgoing monthly payment. Stretching the loan over a longer term will mean much more interest accrues but may mean you have a more manageable outgoing payment. That decision will be up to what best suits your business.
- Fixed versus variable rates - some lenders may offer the borrower the choice between a fixed rate of interest and one that is variable, that is, can change with the general level of interest rates. Fixed-rate borrowing will mean you know what interest rate you are going to pay and what your repayments are each month, but on average it can be more expensive. This is because lenders see themselves as taking more risk on fixed-rate lending as they may lose out if interest rates increase. Generally, variable rate borrowing is cheaper, but it carries a larger risk to the borrower as interest payable may increase if interest rates rise causing monthly payments to rise.
- Debt/financial covenants - debt covenants, also known as financial covenants, are restrictions that lenders can include within a loan deal. They tie the borrower into an agreement in order to approve the loan. A financial covenant can be an affirmative (you must do) or a negative (you must not do).
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What is equity finance?
Sometimes called equity investment, this method of financing is where you sell shares in your business, either to existing shareholders or new investors.
Some things to consider when taking on equity finance are:
- Unlike a business loan, equity finance does not carry a repayment obligation. Instead, investors buy shares in your company to make money through dividends (a share of the profits) or by eventually selling their shares.
- Common equity finance products include angel investment, venture capital and private equity.
- The key with equity financing is to know who your potential investors are and be confident that you are happy to share the ownership of the company with them.
- The business owner/investor relationship is key to the success of any enterprise.
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Which is right for me?
When you’re looking for additional funding to support your business plans and you can’t raise it from within, there are always going to be pros and cons to consider.
The benefit of debt financing is that you get to keep control of the company, but you also have to repay whatever money you borrow and may be charged interest.
Equity financing means you won’t have to repay the money you receive, but you will have to share your profits and be accountable to your stakeholders.
If you’re unsure what is best for you, speak to an UMi adviser on 0330 124 7305.
Next steps...
- Look at your current cash reserves and whether or not you can fund your new projects from existing sources.
- Consider whether you want to take out a loan or sell part of your company to raise funds.
- Find lenders using the UMi Loan Finder Tool.