Debt vs. Equity Financing

AuthorLaurie Hillstrom

Page 159

Debt vs. equity financing is one of the most important decisions facing managers who need capital to fund their business operations. Debt and equity are the two main sources of capital available to businesses, and each offers both advantages and disadvantages. "Absolutely nothing is more important to a new business than raising capital," Steve Jefferson wrote in Pacific Business News (Jefferson, 2001). "But the way that money is raised can have an enormous impact on the success of a business."


Debt financing takes the form of loans that must be repaid over time, usually with interest. Businesses can borrow money over the short term (less than one year) or long term (more than one year). The main sources of debt financing are banks and government agencies, such as the Small Business Administration (SBA). Debt financing offers businesses a tax advantage, because the interest paid on loans is generally deductible. Borrowing also limits the business's future obligation of repayment of the loan, because the lender does not receive an ownership share in the business.

However, debt financing also has its disadvantages. New businesses sometimes find it difficult to make regular loan payments when they have irregular cash flow. In this way, debt financing can leave businesses vulnerable to economic downturns or interest rate hikes. Carrying too much debt is a problem because it increases the perceived risk associated with businesses, making them unattractive to investors and thus reducing their ability to raise additional capital in the future.


Equity financing takes the form of money obtained from investors in exchange for an ownership share in the business. Such funds may come from friends and family members of the business owner, wealthy "angel" investors, or venture capital firms. The main advantage to equity financing is that the business is not obligated to repay the money. Instead, the investors hope to reclaim their investment out of future profits. The involvement of high-profile investors may also help increase the credibility of a new business.

The main disadvantage to equity financing is that the investors become part-owners of the business, and thus gain a say in business decisions. "Equity investors are looking for a partner as well as an investment, or else they would be lenders," venture capitalist Bill Richardson...

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