Debt Versus Equity Financing

“What Are The Main Differences Between Debt And Equity Financing”?

While there are many shades of gray between debt and equity financing, I’m going to take a stab and providing some of the more prominent distinctions most common between the two sources of business financing.

My motivation for writing typically comes from the discussions I’ve had during the week with clients, business people, lenders, and investors and this post follows the same basic source of inspiration.

Individuals looking for business financing are many times looking in the wrong places or asking for the wrong form of capital, most typically debt when they should be looking for equity.

A debt based lender is someone who is extending capital typically for a fixed interest rate and repayment term, where the actual interest rate and terms quoted are indicative of the level of risk associated with the use of funds and with the business as a whole. This means that the risk must be readily quantifiable in some way to place a cost to any money that gets borrowed.

With debt financing, there also needs to be a high probability of repayment of the debt in a timely fashion and if there is not, then there will be other actions the lender can take to reclaim what is owing to them.

Equity financing in many ways is the opposite of debt financing in that there many times is no set repayment term and the return on capital provided is a share of the future profits compared to a fixed rate of return.

As mentioned at the outset, there are infinite variations around either a debt or equity financing theme, but for the most part, if you don’t have a readily quantifiable risk with a clear means to repay the debt in one or more different ways, then you are looking for equity financing.

This is not to say that absolutely no one would provide you with a loan, confirming the notion that anything is possible…but not probable.

Regardless of the form of capital, if you don’t have something tangible or intangible to leverage, then its very unlikely you’re going to find much of either.

A well established cash flow is more likely to be able to acquire debt than a developing cash flow. And if a developing cash flow can acquire debt financing, its going to be at a higher price in accordance with the risk associated with growth and development.

In the debt financing world, regardless of the financing model, cash is basically king as loans need to be serviced and servicing comes from the cash flow generated from the business.

In the equity financing world, opportunity and cash are both very important, with proven opportunity capable of securing equity financing before cash flow is established.

The key point here is that “getting a loan” is not likely going to happen unless you can provide a lender with a high degree of confidence that they’re going to get their money back and their cost of money, in a timely fashion.

Securing equity can potentially be far more difficult to secure, but near impossible if you don’t have something of real value to leverage, in which case you would likely better off asking for neither.

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