Equity vs. Debt: Definitions, Types, Pros and Cons

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“Debt” involves borrowing money to be repaid, plus interest, while “equity” involves raising money by selling interests in the company. Essentially you will have to decide whether you want to pay back a loan or give shareholders stock in your company.

Equity vs. debt | Stocks and bonds | Finance & Capital Markets | Khan Academy

What is debt financing?

There are many types of debt financing available to business owners. They include:

What is equity financing?

Equity financing means raising money by selling interests in the company to an investor in exchange for capital to help you grow your business.

For example, you create and distribute T-shirts. Next, you, need money to buy a warehouse to store inventory and use for packaging. You sell 5% interest in your company to an investor willing to provide the capital the company needs to expand its operations. The investor now owns 5% of the company and can weigh in on important business decisions.

Types of equity financing

If you want to raise money for business growth, its important to know the different types of equity financing available to you. They include:

Example of equity vs. debt financing

You own a bicycle company and want to secure a factory where you can put bikes together more quickly to meet the increasing demand for your bikes and accessories. Youll also need to hire employees to work in the factory and buy more equipment to maintain operations.

To do this, you need $10 million in capital. To raise the money you need, you can either choose equity financing, debt financing or a combination of the two.

With equity financing, you might approach an investor for $10 million in capital in exchange for a 20% equity in your business. This investor would own 20% of your company and make business decisions alongside you and other owners. All would benefit from the companys future success.

With debt financing, you might approach a bank and take out a $10 million loan with a 2% interest rate that you must pay back within five years.

Another choice is to combine the two types of financing. You might ask an investor for $5 million in exchange for 10% ownership in your company. You then borrow $5 million from a lender to be paid back with interest in three years.

How to choose between equity and debt financing

When you consider financing to expand your business, its crucial to think about your unique situation. Take into account your current cash flow and which financing options are easier for you to obtain. Youll also need to decide how important it is to retain ownership in your company.

If you are the only owner, you must decide if you are OK with an investor becoming your business partner. If there are other owners in the business, everyone should agree to sell ownership equity to an investor.

Advantages and disadvantages of equity and debt financing options

Learn more about the pros and cons of each type of financing option:

Equity financing advantages and disadvantages

The advantages of using equity financing include:

The potential disadvantages of using equity financing include:

Debt financing advantages and disadvantages

The advantages of using debt financing include:

The potential disadvantages of using debt financing include:

FAQ

What is difference between debt and equity?

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.

Which is better debt or equity?

If you have patience and segregate your portfolio into different types of funds, you will see that equity funds are much better than debt funds in the long run. On what basis mutual funds are categorized into equity and debt? Mutual funds tend to invest in different kinds of financial instruments in the stock exchange.

Which is more risky debt or equity?

It starts with the fact that equity is riskier than debt. Because a company typically has no legal obligation to pay dividends to common shareholders, those shareholders want a certain rate of return. Debt is much less risky for the investor because the firm is legally obligated to pay it.

Is equity or debt safer?

Since equity financing is a greater risk to the investor than debt financing is to the lender, the cost of equity is often higher than the cost of debt.

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