Debt vs Equity Financing

By Shazaib Rashid, JD Candidate 2024 | UCalgary Law

Introduction
Starting and growing a business requires a significant number of financial resources and is one of the most crucial aspects of achieving success is raising capital.[1] Insufficient funding can hinder a business from taking off, sustaining operations, or competing effectively in its industry. As such, understanding financing options is an essential skill for any entrepreneur who wants to succeed in today's competitive marketplace.
As a startup, you have several financing options to consider, including debt and equity financing. The decision between the two can be challenging, as both have their advantages and drawbacks. Generally depending on multiple types of sources of capital will afford more flexibility and reduce expose to risks in financial markets.[2]
In this blog, we will discuss the benefits and drawbacks of debt and equity, provide examples, and give considerations for when to use each one.
 
Debt Financing
Debt financing involves borrowing money from a lender and paying it back with interest over a specific period.[3] Examples of debt financing include business loans from banks, credit unions, or other financial institutions, merchant cash advances, personal loans, lines of credit.
 
Benefits of Debt Financing

• Lower Cost: Debt financing is generally less expensive than equity financing because lenders usually charge lower interest rates than investors expect in return for equity.[4]
• Control: With debt financing, the lender does not have a say in how the business is run. The lender only has the right to be repaid the principal and interest.[5]

Drawbacks of Debt Financing

• Risk: If the business is unable to pay back the loan, it may default, and the lender may seize the company’s assets.[6]
• Repayment: Debt financing requires regular repayment, which can put a strain on the company’s cash flow.[7]

 
Debt financing is an attractive option for startups that want to maintain ownership and control of their business. However, it is not ideal for long-term funding needs.
 
 
 
Equity Financing
Equity financing involves selling ownership to investors in exchange for funding.[8] Examples of equity financing include angel investments, venture capital investments, crowdfunding, initial public offerings.
 
Benefits of Equity Financing

• No Repayment: Unlike debt financing, there is no requirement to repay the investment, which can provide greater flexibility for the business.[9]
• Expertise: Investors often bring valuable expertise and connections to the company, which can help the business grow.[10]

Drawbacks of Equity Financing

• Control: With equity financing, investors typically have a say in how the business is run and may require seats on the board of directors.[11]
• Cost: Equity financing can be more expensive than debt financing because investors typically require a higher return on their investment.[12]

 
Equity financing can be an attractive option for startups because it does not require repayment of the investment. However, it can be costly for the business.
 
Considerations for Choosing Debt or Equity Financing
When deciding between debt and equity financing, there are several considerations to keep in mind as these can significantly influence your decision when choosing between debt and equity financing. Some critical considerations are risk tolerance, funding needs, and growth potential.
 
Risk Tolerance

• If you have a low-risk tolerance and want to maintain control over the business, debt financing may be a better option for you.
•  If you have a high-risk tolerance and are looking for significant funding and expertise, equity financing may be more suitable.

Long-Term Funding

• If you have short-term funding needs, debt financing may be more suitable as it offers a fixed repayment schedule over a specific period.
• If you require significant funding for long-term growth, equity financing may be a better option.

Growth Potential

• Equity financing is typically better suited for high-growth startups as it provides access to significant funding and expertise from investors.
• Debt financing may not be the best option for startups with high growth potential as it offers limited funding and may have stricter repayment terms.

 
In conclusion, raising capital is an essential aspect of starting and growing a business. With careful consideration and planning, you can make an informed decision that aligns with your goals and helps your business thrive.


[1] Bryce Tingle, Start-Up and Growth Companies in Canada, 3rd ed (Canada: LexisNexis, 2018) at 69.
[2] Ibid
[3] Ibid., at 70 – 73.
[4] Ibid
[5] Ibid
[6] Ibid
[7] Ibid
[8] Ibid., at 73 - 76
[9] Ibid
[10] Ibid
[11] Ibid
[12] Ibid
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