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Debt or Equity Finance – What’s Right for Your Business?

woman at desk choosing between debt finance and equity finance

All business finance falls into two categories – debt or equity. Understanding these forms of finance will help you decide what’s right for your business. Let’s start by looking at the definitions of debt finance and equity finance.

Definitions of debt finance and equity finance

  • Debt finance – this is money you borrow from an external lender that you will eventually need to pay back along with interest.
  • Equity finance – this is money you get in exchange for outside ownership of part of your business.

Types of debt finance

Debt finance can take many forms, including:

  • Unsecured business loans – no collateral is required when taking out an unsecured business loan from a bank or other lender, but the interest rate will be higher, and you might get less funding than you would with a secured loan. Online cash flow loans fall into this category – they can usually be obtained quickly with no collateral attached.
  • Secured business loans – a secured business loan requires collateral, such as residential or commercial property, machinery and equipment. With lower risk to the lender, you can get a lower interest rate and access to more funds with a secured business loan. Typically, secured business loans have a more complicated application process and take longer to approve – from a few weeks to several months.
  • Business overdraft – with a business overdraft, you can have a negative balance in your bank business transaction account. You pay interest on the amount you have overdrawn plus other fees and charges. Most business overdrafts are payable upon demand by the bank, so the overdraft amount must be paid immediately if the lender demands it.
  • Line of credit – with a business line of credit you can draw up to an agreed amount when needed. As with a business overdraft, you only pay interest on the funds you are using at a given time.
  • Suppliers – you can get short-term trade credit (usually 30 days) from your suppliers. Of course, you will want to pay suppliers on time to maintain a positive business relationship.
  • Fixed rate loan – with a fixed rate loan, the interest is set for the period of the loan.
  • Variable rate loan – the interest rate on a variable rate loan will change based on the lender’s discretion. Usually, changes are connected to Reserve Bank changes in interest rates.
  • Factoring – this is where you sell your outstanding invoices to a factoring company that will get payment from your debtors. You sell your debts at a discount (10%, for example) so this can be a costly form of debt finance.
  • Family and friends – you can get a business loan from family members and friends. However, be sure you keep it on a business level. This means having a written agreement in place and following through as agreed. A loan from family and friends can offer more flexibility, such as making repayments when you have good cash flow.

Types of equity finance

Some of the types of equity finance include:

  • Self-funding – also called bootstrapping, this is where you invest your own money and revenue from the business to fund growth. According to one study, around one-third of third of start-ups begin with self-funding.
  • Family and friends – some small businesses ask family and friends to help fund their businesses in exchange for ownership of a portion of the business. As with loans from family members and friends, you will want to keep it professional and agree on the details in writing.
  • Private investors – these are investors who provide funds for your business in exchange for a share of your business, including profits. In addition, a private investor with business experience could act as an advisor as well as an investor.
  • Venture capital – typically, venture capital is provided by big firms that invest large amounts in start-ups that have the potential for large growth and profits. In exchange for their investment, venture capitalists usually want to control a large share of the business and will take an active role in providing management expertise to grow the company. Most businesses don’t appeal to venture capitalists, so it usually won’t be a viable option. In fact, research has shown that only 6.5% of fast-growing businesses raised venture capital.
  • Share market – to get money on the share market, you can offer shares through an Initial Public Offering (IPO) where you offer shares to the public. This option is complex and expensive so not viable for most SMEs. With an IPO you also take the risk of not raising enough funds due to unfavourable market conditions or lack of interest in your offering.
  • Crowd-sourced funding – in Australia, you can raise equity from investors through online platforms. With crowd-sourced funding, you typically raise small amounts of money from many investors.

Understanding the pros and cons of debt finance and equity finance

Here’s a quick overview of the pros and cons of debt and equity finance.

Pros of debt finance Cons of debt finance Pros of equity finance Cons of equity finance
Debt finance can be a quick way to raise funds, depending on the form you choose. For example, with unsecured online lending, you can get funds in 1 to 2 days if you meet certain criteria. Depending on the type of debt finance you choose, you could end up paying a lot of interest. Unlike with debt finance, you don’t have to pay interest on the funds you raise through equity finance. Most forms of equity finance can take a long time to obtain compared with debt finance.
With most business loans, you choose how the money is spent. You might not qualify for many forms of debt finance if you don’t have a good credit score and strong financials. Also, it can be difficult for new businesses to get debt finance. If you find the right investors, they can bring experience, advice and connections with them. These relationships could be invaluable for growing your business. With equity finance, you give up ownership and control of your business. You might not agree with your investors on big decisions affecting the direction of the business.
You don’t give up control or management of your business with debt finance. Your assets could be seized if you are not able to repay the money you have borrowed. You don’t have to repay funds or risk losing your assets if your business fails.

There are many options available when choosing debt finance, so you will usually be able to find something that covers how much you need and enables you to make repayments based on your cash flow. For a summary of business finances, read The Complete Guide to Business Loans in Australia.

If you want to get an estimate for business loan repayments, check out our business loan calculator.

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