SME Financing: The Difference Between Equity and Debt

There are two major categories of business finance, you have probably heard analysts and reporters talk them when they’re explaining how businesses and startups raised funds. They are Equity and Debt finance.  This article has been written to help you understand what they mean individually and to understand their difference better.

Debt Financing or debt finance simply means asking for finance or capital from a lender (banks, or investors) which you’re required to repay (in installments) with interest over an agreed period of time.

The full amount you receive is called principal and the extra fee you have to pay to your lender is called interest. So when you ask your bank for a loan you’re basically using debt to finance your business.

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One major area of advantage for debt finance is that the business owner does not lose any part of his/her business to the lender unlike equity financing. This is an important criteria as most business owners naturally don’t want to give up any part of their business.

But this advantage comes with a disadvantage which is that the business has to pay a steep sum in interest and the repayment is fixed regardless of the state of the business.

Debt Financing is the most popular financing option for small businesses that need access to short to medium term finance.

Equity financing means that a business owner sells stake (equity) in their business to investors in exchange for finance.

Investors usually Angel investors or venture capitalists become co-owners of the business in exchange for providing the business with finance.

Funds raised by businesses through equity financing is not expected to be paid back since your lenders can share in your profits. This is perhaps one of the advantages of equity financing, that businesses are not required to pay back the sum raised especially because it gives the business owner time to fully utilize the funds to grow the business unlike debt finance.

Apart from the fact that equity financing is hard to come by, one major disadvantage is that business owners lose a part of their business to lenders and can possibly be evicted from their own businesses if the investors deem it fit.

The truth however is that equity financing is more suited for high growth technology startups and businesses often without a clear path to profitability (they need a long termed finance) but investors find them worthwhile because if their potential for a  returns on their investments.

So, hopefully by now you have a better much better understanding of the differences between debt and equity financing. If you have any questions please ask below by leaving your comments below.

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