Debt vs Equity Financing

A brief overview of the basic types of financing may be helpful to understanding which options might be most attractive and realistically available to your particular business. Typically, financing is categorized into two fundamental types: debt financing and equity financing.

Debt financing means borrowing money that is to be repaid over a period of time, usually with interest. Debt financing can be either short-term (full repayment due in less than one year) or long-term (repayment due over more than one year). The lender does not gain an ownership interest in your business and your obligations are limited to repaying the loan. In smaller businesses, personal guarantees are likely to be required on most debt instruments; commercial debt financing thereby becomes synonymous with personal debt financing.

Equity financing describes an exchange of money for a share of business ownership. This form of financing allows you to obtain funds without incurring debt; in other words, without having to repay a specific amount of money at any particular time. The major disadvantage to equity financing is the dilution of your ownership interests and the possible loss of control that may accompany a sharing of ownership with additional investors.

Debt and equity financing provide different opportunities for raising funds, and a commercially acceptable ratio between debt and equity financing should be maintained. From the lender's perspective, the debt-to-equity ratio measures the amount of available assets or "cushion" available for repayment of a debt in the case of default. Excessive debt financing may impair your credit rating and your ability to raise more money in the future. If you have too much debt, your business may be considered overextended and risky and an unsafe investment. In addition, you may be unable to weather unanticipated business downturns, credit shortages, or an interest rate increase if your loan's interest rate floats.

Conversely, too much equity financing can indicate that you are not making the most productive use of your capital; the capital is not being used advantageously as leverage for obtaining cash. Too little equity may suggest the owners are not committed to their own business.
Lenders will consider the debt-to-equity ratio in assessing whether the company is being operated in a sensible, creditworthy manner. Generally speaking, a local community bank will consider an acceptable debt-to-equity ratio to be between 1:2 and 1:1. For startup businesses in particular, the owners need to guard against cash flow shortages that can force the business to take on excess debt, thereby impairing the business's ability to subsequently obtain needed capital for growth.

Caution
Exercise caution when making equity contributions of personal assets (cash or property) to your business. Usually your rights to that contribution become secondary to the rights of business creditors if the business goes bad. Alternatives to outright transfers of capital to the business may be secured loans or "straw man" transactions (you loan money to a third-party relative or friend who then loans the funds to the corporation). The insider then takes a secured interest in the property.