Debt financing involves borrowing money whether from a bank or another financial institution or from a government-funded agency. The terms of debt financing depend on a range of factors including the borrower’s credit history, financial performance, and/or willingness to place collateral. Equity financing on the other hand, involves selling a stake in the business in exchange for financial capital .
They are both same because the probability of obtaining favorable terms depend upon the financial position and prospects of the business. The higher the risk, the less favorable the terms would be and vice versa. In addition, both loan providers and equity investors usually monitor the performance of the business to lower their risk.
Both debt financing and equity financing have their advantages and disadvantages. One of the benefits of debt financing is that the owner retains ownership control and can run the business as he sees fit. Another advantage is that the financing terms may be quite favorable if the business already has strong financial position or credit history. The main disadvantage is that principal and interest obligations have to be paid on regular intervals irrespective of the financial performance of the business and this may turn out to be quite painful in struggling times. The main benefit of equity financing is greater profitability and liquidity due to the absence of interest and principal payments. Even though the business may pay dividends, it has a choice and could choose to skip it in order to reinvent in the business or weather difficult economic climate. Another benefit is that equity investors are often experienced professionals and could guide new business owners with little experience. The main disadvantage is loss of equity stake and potential interference in management affairs.
I believe equity financing has a higher probability of success. First of all, liquidity and earnings are even more important to new businesses who have limited resources as well as access to funding sources. New businesses often fail so the guidance of experienced professionals is also a huge plus. It may lead to some erosion of equity stake but the owner may still end up with greater assets if the business survives early years and expand. A great example is Facebook whose founder Mark Zuckerberg ended up with less than 50 percent stake but he might not have been a billionaire if it were not for the guidance of venture capitalists.
- Harley, K. (2013, June 25). The Difference Between Debt and Equity Financing for Your Small Business. Retrieved November 27, 2013, from http://www.mint.com/