Debt vs. Equity: The Pros & Cons

What’s the best way to raise capital for your business? Borrow money and take on debt, or bring in equity funding by selling a stake in the company? Debt financing, typically a business loan or line of credit from a financial institution, requires paying off that loan with interest. With equity financing, a company sells some ownership of the business to a private investor in exchange for the desired capital.

Examining these two options reveals the benefits and drawbacks of each.

Weighing the Pros and Cons

Pros of Debt:	Cons of Debt:
Once the loan is repaid, the debt is gone. A loan does not change the company ownership. Loans are typically less complicated to obtain. It’s typically a less expensive source of funding. You know upfront how it will impact cash flow. Interest paid on the debt may be tax deductible	Interest rates may not be favorable when you want to borrow. Approval may be difficult if your company is leveraged or there’s insufficient collateral. The bank may require certain covenants or requirements while there is an outstanding balance.
Pros of Equity:	Cons of Equity:
Typically there is no collateral, which can be beneficial for service industry companies or startups. It’s an option when the company cannot qualify for a bank loan. You avoid taking on debt.	You are giving up a portion of the company to the investor. Depending on the terms of the deal, the percentage of profits you share with investors may cost more than the amount you originally wanted to borrow. Finding investors that offer competitive terms can be difficult and time-consuming. There may be unknown impacts on future cash flow..

How to Determine What’s Best for You 

Debt financing is typically considered when a company is established and has predictable cash flow, stable revenues and assets (collateral) on its balance sheet.

Startups that do not qualify for traditional bank financing or companies with erratic revenues and net profits, and insufficient collateral are often candidates for equity financing.

When embarking on a capital raise, pulling together a team that will listen and understands your business and ultimate goal is a vital first step. “We encourage business owners to include their banker, CPA and attorney,” said PNC Senior Vice President and Commercial Relationship Manager Jessica Cuffia-Corlette.

The banker’s role is to discuss the pros and cons of both options and explain the potential effects each form of financing could have on your business and goals down the road, said PNC Bank Underwriter Julie Battershell. “Your banker should always encourage you to discuss the transaction with your CPA and legal team,” she said. “They should provide information, but not make your decisions.”

The next step is determining a company’s capacity for debt — how much money can you borrow and retain the company’s current health. With interest rates rising, it’s important not to be over-leveraged — to borrow so much that you can’t make monthly payments while covering operating expenses, said Cuffia-Corlette.

Alternatively, you can get financing with a fixed interest rate, said Battershell. Even in an environment when interest rates are rising, it’s important to consider the effect of debt versus equity over time. “Debt financing may be expensive in the current rate environment. However, it may be cheaper over time since there is an end date to the payments,” she said. On the other hand, with equity financing, some of your profits will go to the investor as long as they remain an owner.

If your company urgently needs capital, it could be better to seek a private investor. “A private investor may help ensure that the company has the funds needed to fulfill a new or increased contract or make needed improvements to their facility that will generate perpetual income,” said Battershell.

But when bringing in equity, owners should consider a future in which your investors have a voice in business decisions, said Cuffia-Corlette. There's typically some exchange for ownership, such as non-voting stock.

Tapping into both debt and equity financing can be a solution for larger and more complex transactions.  “Using both gives a company more flexibility to use the method that is most beneficial for them at that point in time,” said Battershell.

Debt vs. Equity — Real Scenarios

Like many entrepreneurs, financing growth was challenging for Gina Kallick, who owned a consumer services business for 25 years. “After many rejections to secure bank financing, my CPA introduced me to a banker who believed in me and helped me secure the capital I needed. That relationship was extremely valuable, and I followed him as he moved up the ladder in the industry.”

Kallick, now a Pittsburgh-based business coach and angel investor in women-owned or run startups, offered this advice on seeking financing: “It only takes one relationship, one investor, one banker to get started. Ask for introductions and referrals to decision makers.”

Leverage your network and be prepared to pitch your business and growth strategy (or exit strategy if you are pitching to an investor) with a tight, clean deck, she said. “Tell your story and know your numbers. Without capital, I would not have been able to scale my business, which ultimately led to a successful exit with an international conglomerate.”

Circumstances often dictate what type of financing is most advantageous. For instance, Cuffia-Corlette said she had a client who knew their business could grow significantly, but they couldn't do it alone. “They knew the growth potential, but they wanted to retire before the time it would take to implement that strategic plan,” she said. “So, they found an equity partner to accelerate growth, and we worked with them throughout the process. It was a win-win for everyone.”

Some companies want to expand with a new line or new vertical to produce something themselves rather than rely on the supply chain.  “Banks can do a debt capacity analysis and determine whether the company should buy that new piece of large equipment or invest in more human capital,” said Cuffia-Corlette. “Those are really rewarding situations because we work together as a team.”

“Whatever you decide,” said Battershell, “having a team of experts in your corner to find the right path will make all the difference.