Home Your Business Starting Out What is the difference between debt and equity finance?

Starting Out

What is the difference between debt and equity finance?

One of the hardest decisions when starting a business is deciding how you're going to finance it. Common financing options are debt and equity, however, if you're just starting out it’s important to understand the pros and cons of each before you get going.

By Siobhann Provost Senior Writer, My Business

Most start-up businesses are going to require some finance to get off the ground. Government grants are worth exploring as a grant provides money that does not need to be paid back if the business is eligible and approved. The business owner may have personal money to put towards the business yet may need additional funding to get off the ground.

Extra funds can be obtained through traditional debt finance which is taking out a loan from a bank or other lender. This can be challenging to secure if the business is unproven. Alternatively, equity finance is sourcing money from within your business by selling shares. Similarly, it can be high risk for investors to gain their money back as the business is unproven to be financially viable.

It’s important to get advice from an accountant with industry and small business experience before making any decisions. An accountant’s advice will assist in deciding between a loan or equity as well as the tax obligations for each.

Debt Finance

There are multiple options to secure debt finance, for example self-funding, a business loan, a personal loan, a loan from family or friends, debt-based crowdfunding. A home equity loan (if the business owner owns a property) is available too, but is a much higher risk option.

Advantages

The business owner maintains total control over the business, versus having a portion owned by investors.
Paying off the interest on a business loan may be a deductable business expense.
If family and/or a friend(s) are willing to loan money favourable loan repayments and interest rates can be negotiated to provide flexibility in the early business years.

Disadvantages

Paying back a loan at the agreed times in the early business years is challenging whilst earning a steady profit.
A bank loan may engage debt collectors to obtain money not paid on time.
A home equity loan is a high risk if the business is not successful as the personal home could be sold if unable to meet the loan repayments.
Given the tougher economic environment due to the coronavirus pandemic, family and friends might be impacted and may not have availability to the money they would normally have been able to lend.

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Equity

There are several ways to secure equity whether it is self-funding, family or friends, private investors, venture capitalists or equity-based crowdfunding.

Advantages

Equity sales do not require any repayments which is beneficial and less stressful whilst establishing steady business profits in the beginning years.
An investor does not need to be paid back the initial investment if the business loses money or closes and minimises the business owner’s personal risk.
There is an opportunity to select investors that can provide specific business advice and mentoring the business owner requires.
An equity investment can be more flexible than bank loan terms as it is open to negotiation and can be tailored to the business requirements.

Disadvantages

Having an equity investor may feel like a loss of control of the business as well as a duty to inform the equity investor(s) of all noteworthy business proceedings. It is important to engage with an experienced business accountant to understand the obligations and legalities of equity investing.
Part of the equity investor(s) arrangement will include paying a portion of the business profits to the investor(s). Whilst the initial equity helped the business start-up it is a trade-off as the repayment money goes to the investor(s) instead of reinvesting in the company.

Disclaimer: This does not constitute financial advice and individuals should seek information from their financial advisor before making a decision.

Siobhann Provost Senior Writer, My Business

Siobhann has over 18 years human resources business partnering experience in large organisations. She more recently established and led a people advice team of senior workplace advisors before moving into content writing.

Accounting