Almost every kind of finance, whether it be bank loans, leasing, crowdfunding or cashflow management, falls into one of two categories: debt or equity.
Both are viable options for businesses seeking finance. However, they carry different sets of advantages, disadvantages and criteria to fill – meaning there are specific contexts where each may prove useful. In some scenarios, you may even use a mixture of both debt and equity to fill your funding requirements.
Before deciding whether to pursue debt or equity, it is essential to comprehend the ins and outs. We have created this simple guide to debt and equity finance – as well as which you should use, dependent on the unique needs of your business.
What is debt finance?
Debt finance is when you borrow money that will be repaid within a set timeframe – so you are indebted to the lender. In most cases, the owed money is paid back in affordable instalments as outlined by the agreed payment plan. Payments can be spread out over months or even years, depending on the size of the loan. However, these instalments will be subject to interest, meaning you end up paying back more than you initially borrowed.
Example of debt finance include:
- Bank loans
- Alternative loans
- Hire purchase or leasing
- Trade finance
- Stock finance
- Mortgages
- Invoice finance
Debt finance comes in two forms: secured and unsecured. With secured loans, you will need to provide some collateral to borrow against, such as assets and/or a personal guarantee. This means that, if you fail to keep up with repayments, this security can be seized by the lender to clear the balance.
With unsecured debt, you do not need such collateral, although there is generally a requirement for a personal guarantee – but interest rates tend to be higher and it is harder to access sizeable sums.
The most vital thing to bear in mind with debt finance is the need to repay the money you borrow in the agreed timeframe. If you fail to do so, it could translate to increased fees and debt, cashflow blockages, a worsening credit rating or even bankruptcy.
What is equity finance?
Equity finance is closely associated with capital investment. It is when you are provided with funding for your business in exchange for shares, held by investors. The period of the investment may vary but tends to be for a number of years.
Unlike debt finance, you do not need to repay investors or worry about interest. Instead, they receive dividends if the business is able to pay them from surplus profits or appreciation in the share value. You may have the option to buy them out down the line to regain control of your company – however, some enterprises will have the same investors holding equity for its entire lifespan.
Examples of equity finance include:
It is noteworthy that with equity finance, you cede ownership and potentially control of your enterprise alongside the shares. This means that those who own shares have a say in your operations, and you may need to run significant decisions past them before you can implement them.
The percentage of shares you offer will vary and will be a point of negotiation. It is also possible to have multiple shareholders (either from high net-worth individuals or investment groups) to maximise funding.
Which should I use?
Debt and equity have their pros and cons, and both are valid options for generating substantial funds. Which you choose to use will depend on your preferences as well as the ability to fill the criteria.
When pursuing debt finance, you usually need to undergo a lengthy application process. You will need to provide historical accounts, management accounts, financial forecasts and consider the loan size that you need (thus assuring lenders that you will be able to repay). You may also need to have security in place, as already discussed. If your company does not have adequate assets or you do not wish to use a personal guarantee, you may struggle to access the working capital you need.
There may also be certain fees related to the administration of a loan, such as a lender’s fee, which you will need to account for.
In the case of equity finance, you won’t need security and may not need to fill out a lengthy application. However, you will still need to provide investors with a pitch deck and business plan as well as determine your valuation to convince the relevant investors of their potential return. This will mean crafting a compelling pitch that showcases the value of your enterprise.
If it’s a high-risk business or idea you are hoping to fund, equity investment may work best. Traditional lenders tend to be risk-averse, so may be resistant to offering money to you – particularly if you do not have security in place. Equity investors, such as angel investors and venture capitalists, tend to be more open to risk so more willing to lend to you. If you are set on debt finance, you may wish to research alternative lenders, who will be more flexible in who they accept for loans.
Conversely, if you are seeking funding to fill a gap in your financials – such as after a period of downturn – attracting investment may be a challenge, unless you have a proven track record. Investors seek reasonable returns on the money they provide, so look for businesses which offer high growth potential. If you are experiencing a downturn, they will be unlikely to want to invest in your business unless you can convince them of your future growth. In this context, debt finance may be more amenable to your needs by offering the funding you need, especially if you are able to provide a personal guarantee or other security.
So, generally speaking, equity solutions are great for growth projects or funding for high-risk enterprises. Debt finance suits businesses seeking support to address financial obstacles or those that offer reduced risk through security, good trading histories or healthy credit history. Debt funding also commonly applies to cashflow management, offering short-term options which free up working capital and allow your operations to run smoothly.
It’s also crucial to bear in mind the implications of each finance type. With debt finance, you need to be confident in your ability to repay the loan and comfortable with interest rates. If you feel you cannot meet the repayment plan, it is probably an indicator that debt funding isn’t for you. Similarly, if you aren’t open to the idea of diminishing control in your business to shareholders, equity finance may not be suitable.
It is worth noting that you are not limited to either debt or equity. Many companies will use a combination of both, encompassing different finance types, to address the needs of their business and maximise the funding raised. Some types of finance will even blend debt and equity together, such as mezzanine finance.
Get advice
Understanding the differences between debt and equity finance will allow you to choose the right option for you and address the unique requirements of your company. If you are struggling to determine which avenue is the best for you, our team of experts will provide impartial advice to help you refine your choices.
We also offer access to a range of debt and equity solutions and support in how to apply, so that you can take the next step in your financial journey.