Finance falls into two major categories: debt or equity. Debt refers to finance that you need to repay, such as bank overdrafts, commercial loans, mortgages and hire-purchase. Equity relates to funding provided by investors in exchange for shares in your company that they hope will grow in value.
People may have a preference for one or the other, especially upon starting a new venture. In some cases, they may use a combination of both. However, it’s common to hear people say that debt is cheaper than equity, which may sway your decision when choosing a funding solution.
This blog answers why debt is reportedly cheaper than equity and what it means for your business.
Why is debt cheaper than equity finance?
When people say debt is cheaper than equity, it doesn’t refer to the amount of funding you can get, as both forms can offer substantial amounts in the right circumstances. What it does refer to is the costs associated with securing financing.
When you take on debt finance, you retain 100% of the equity in your company. This means you do not need to pay investors dividends or be beholding to them. You will only need to repay the loan given to you.
By retaining the equity in your business, you will also be able to get better funding terms in the future with lenders and investors being more inclined to back you. Your shareholding isn’t diluted, you are still in control of your business and all the profits from your business can be reinvested in your business.
Another factor to consider is the effort required to obtain equity. In order to secure investment, you need to have a proven value proposition that highlights your potential, backed by extensive documentation and a robust business plan. All of this takes time, effort and costs to finalise. In some cases, the process can take months or even years to complete.
Debt funding, on the other hand, tends to be a shorter process. Depending on the type of loan you are applying for, you can get finance in days. There’s also typically less scrutiny involved, provided you show that you have the capability to repay the loan.
Finally, debt tends to be a short-term solution compared to equity. Once you have repaid the amount owed, your commitment to the lender is done. When dealing with equity, you need to create and agree on an exit plan with investors for when either one of you will step away from the business. They will continue to have a role in your business until that point, meaning they can influence your decisions and share in your profit.
How do I choose debt or equity?
When you are pursuing funding, you need to make the critical choice of debt or equity. There’s no right or wrong answer about which is best. It is entirely dependent on your business needs and preferences.
If you are interested in equity, you shouldn’t be deterred by claims that debt is cheaper. However, you need to be aware of what you are committing to when you accept investment in your business. If you are willing to put in the work to secure an investor and embrace a long-term relationship with them, including sharing in the profits via dividends and their share of any future sale of the company, there is no reason it won’t be beneficial for your business. Many start-ups and growing companies rely on equity, which goes some way to proving their worth and can potentially enable you to receive larger sums of finance.
However, if you can afford the repayments and are looking for less commitment, debt finance might be a better option. This is because it still leaves you open to equity in the future, without having your shareholding diluted, plus you can retain complete control of your business. It also offers quicker access to money, which is particularly relevant where the need is more urgent.
If you’re still unsure of the advantages of debt versus equity and which might be right for you, it’s worth consulting a financial advisor who can take you through each option.
Conclusion
In many ways, it is fair to say debt is cheaper than equity in terms of the level of return that a lender expects compared to an equity investor. However, equity is may still beneficial for businesses who early in their journey, start up or scale up, where consistent profits have not yet been achieved.
Equity can also be an excellent option for businesses who have found themselves rejected for traditional forms of debt funding, provided they can find the right investor.
Understanding the implications of each will enable you to select the best choice for your business and fulfil your funding needs.
If you are looking for external finance, we can help you identify the right debt or equity finance solutions for your business. We can also take you through the options in the market to inform your decision and improve your access to funding.