When seeking capital, it is important to think about what your objective with that money will be. Will it help you achieve a short-term or long-term milestone? Do you need a small amount or a huge sum? This will give you a better idea of what kind of financing is right for you.
Debt financing involves paying back an entity money at a specified time or rate. For instance, a company could issue bonds that pay interest and a principle or it could take out a loan from the bank.
The big advantages of debt financing is that lenders have no right to the company’s future profits, which they would if they had shares (equity) in the company instead. This is a pretty big advantage. Imagine if a rapidly growing company such as Facebook issued shares to early investors in return for capital—the company would have missed out on billions in profits.
A major drawback of taking out debt is that a company will have to pay interest rates according to how risky it is viewed by investors. For instance, with low oil prices, smaller oil producers face the threat of going bankrupt and thus have to pay significantly higher interest rates with investors willing to take the risk of losing their money. Even more so, institutions such as banks will require assets to be put up as collateral in the case the company defaults on its obligations.
Equity financing involves issuing ownership in a company. This gives owners rights to a company’s assets and profits.
The main advantage is that a company is receiving “free” money as there is no interest rate or obligation to pay. Yet this comes with the disadvantage that the owners are diluting their stake in their company.
Deciding What Kind of Financing is Best for You
This involves examining what stage your business is at. If your business is already earning revenue, and you believe you’d be able to pay off the amount you’re intending to raise with future cash flows, it is probably best to take out debt. If your company is pre-revenue or is suffering from turbulent economic events, like low oil prices, it may be best to issue equity in order to avoid paying painfully high interest rates on debt, especially if future cash flows are uncertain.