Businesses can explore multiple financing options to fund their operations. While business loans are the most common method of financing there are other funding options like venture capital, equity financing, etc., available for businesses. Equity financing is one of the popular means of raising capital for businesses. Companies face a dilemma when choosing between a business loan and equity financing. Comparing business loan vs equity financing can help you choose the right option.
What is a business loan?
A business loan is money (i.e., credit option) that can be borrowed from a financial institution by a company/sole proprietor. There are several benefits of borrowing a business loan such as funding any business activity like expansion, starting a new project, renting/leasing a property, buying a new commercial vehicle or equipment, etc.
The amount borrowed must be repaid with interest. Defaulting on a business loan repayment can affect your credit score leading to difficulties in getting future business and personal loans sanctioned. Business loans are also called debt financing because you are financing something by taking on debt.
Some sources of business loans are as follows:
- NBFCs (Non-Banking Financial Company)
- Microfinance companies
- Invoice financing
- Business credit cards
- Personal loans
What is equity financing?
Equity financing is when a company raises finance by selling shares. To understand equity financing you must first understand what equity in finance is. Equity means the total money shareholders will get when all assets are liquidated, and all debts are paid off. Simply put:
Total assets – Total liability = Equity
Equity financing is therefore selling a portion of your equity to raise money for business expenses. This option is availed by companies using two methods issuing the private placement of stock with investors and public stock offerings like IPO (Initial Public Offering).
Listed below are some sources of equity financing:
- Angel investors
- Venture capital firms
- Corporate investors
- Listing on an exchange with an initial public offering (IPO)
Business loan vs equity financing: Understanding their differences
Here is an example to understand these two terms better. Company X wants to finance its new project of upgrading the yarn spinning machine. The owner of the company is exploring two options: equity financing and business loan.
The owner is either planning to sell a 10% equity stake in its business to a private investor in return for ₹50 lakh in capital or obtain a business loan from a bank or NBFC of ₹50 lakh, with an interest rate of 14%.
Look at the table below to know the main differences of business loan and equity financing:
|Business loan||Equity financing|
|Involves borrowing money from a lender like banks and NBFCs||Involves selling equity shares to raise money|
|Have to be paid back with loan interest (and other fees and charges) within a stipulated time to avoid cons of non-repayment of business loan EMIs||Only paid back according to the contract drawn usually once or twice in a year in parts|
|Doesn’t have to sell a part of the ownership of the company||Must give away a part of the ownership of the company|
|Doesn’t reduce the share of profits in future||Future profits have to be distributed among equity shareholders|
The importance of equity financing is that there is no interest to be paid back or a strict stipulated time to pay back the shareholders. The main advantage of equity financing is that it won’t affect your credit history.
A start-up that grows into a successful company will have raised funds through several rounds of equity financing. Since a start-up attracts different types of investors, it usually uses different equity instruments for its financing needs.
To sum up: Selecting between business loans and equity financing
Most companies use a combination of debt and equity financing. This is because equity financing carries no repayment obligation and provides extra working capital while business loans do not require giving away a portion of ownership.
Companies usually make a conscious choice between business loans vs equity financing as it can have long term effects on the company. The choice often depends upon which choice is easier to avail. However, some owners place high importance on maintaining control of the company. The debt-to-equity ratio indicates how much of a company’s capital is financed by debt and equity.