Finance

Difference Between Debt Financing and Equity Financing

johnandrew9841 / 15 Feb, 17 /

Difference Between Debt Financing and Equity Financing

Debt financing and equity financing are both methods of financing a business but they vary greatly in terms of the conditions associated with financing, the type of business, the stage at which a particular business is during its cycle and so on. To have a good understanding and difference between them the following article explains these two financing types individually.

Debt Financing

An acceptable definition of debt financing is

A method of financing in which a company receives a loan against the promise of repaying the loan”

The definition might suggest that this is a quite crude method of financing with high risk for the lenders but there are a lot of factors involved which bounds the debtor to pay back. The financing includes both secured and unsecured loans.
The security in the former case involves a collateral as an assurance of repaying the loan and if the debtor fails to repay the collateral is fortified to settle the debt. The security can include an array of forms including guarantors, equipment, real estate, insurance policies, ware house inventory, display merchandise etc. The security depends greatly on the type of business.

In case of unsecured loan the borrower’s credit worthiness is the main security. This type of loan can range from a few hundred dollars to thousands of dollars all depending upon the borrower’s relation with the bank or any borrower for that matter. This type of debt financing however is usually short termed with high rates of interest. Outside lenders tend to avoid unsecured loans unless you have great credit history with them but even then depending upon the economic conditions or your present financial condition they may require some collateral.

Other than the above two divisions, debt financing is also categorized in terms of the payment period. The three generally known periods are ;

a. Short Term Loans – Typically from 6 to 18 months
b. Intermediate Term Loans – Up to three years
c. Long Term Loans – Are paid back from the cash flow of business normally within five years

For startups the most common way of debt financing is not through commercial organizations but from family and friends but this has a downside as the lenders tend to interfere in the business a lot if they think the business is not running as it they expect it to and this is often the case. Also the laws normally permit this interference of investors.
Debt financing is very luring but many businesses collapse or get damaged greatly for defaulting the payments hence this method should be opted only if one has high confidence in the business.

Equity Financing

A method of financing in which a company issues shares of its stocks to obtain money in return”

To fully understand the concept of equity financing one must be clear of the concept of Venture Capital (VC). This is the money to seed an early stage, emerging and emerging growth companies.
VC is a common form of equity financing used to finance high risk, high return business. The amount of equity financing greatly depends on the stage of a business and the expected risk. The relationship between a venture capitalist and the entrepreneur is also a major factor. Equity financing is normally associated to a startup and emerging businesses.

Venture capitalists (VCs) referred to as “angels” tend to invest in the business sector they are acquainted to, they do not involve in day to day running of the business but try to stay in the loop for major decisions of the business.

Venture capitalists are defined by their investment made in the business’ life cycle. Seed financing, startup financing, second-stage financing, bridge financing, and leveraged buyout are the major types of VCs. As mentioned most of the VCs try to invest in the seed financing stage and second-stage. Although the risk is high but the potential of return is also high and growth is rapid. The wide-ranging types of VC include;

Private venture capital partnerships look for business with a potential of at least 30 percent return on investment each year.
Industrial venture capital pools look for business with higher chances of success these are normally technology related business
Venture capitalists/Individual private investors are normally friends or family and can also include well established people in the concerned area and want to invest more in the sector as they expect it to grow on the basis of their experience.

It is of paramount importance that a person looking for investment should find for investors who have similar interests. The process must be carried out through proper legal channels.

This article is courtesy of Teens Mean Business, featuring thought leadership content by ambitious entrepreneurs & small business owners.

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