Debt vs. Equity vs. Other Forms of Financing: A Comparative Guide

Equity financing is when a company can raise funds for their business in exchange for shares (equity) in their company. This method of financing can be beneficial as it involves little of the owner’s own capital. Debt financing on the other hand is a financing agreement whereby the sum of money required to fund the corporate transaction is borrowed from a lending party, who in return will have securities/ guarantees on that loan in case of liquidation of the company. 

An alternative form of financing that could be useful for startups is through investment including angel investment or venture capitals. Angel investors are often high net-worth people who decide to use some of their wealth to invest in startups. Another form of investing is venture capital finance which is often obtained by startups in exchange for equity in the company. Venture capital investors may also be in the position to offer advice and expertise in exchange for non-executive directorship or position on the board, which could help grow the business. Examples of venture capital funded companies include Deliveroo, Skype, Monzo and Revolut. 

Type of financing	Advantages to businesses seeking finance	Disadvantages
Equity financing	Does not require the use of the company’s own capital. None of the owner’s own capital needs to be used to finance this.  Good solution to any short-term financing needs that may arise before a business is fully operational due to its relative availability and its potentially massive impact on your finances. For business’s early-life necessities, such as office space, training staff and purchasing equipment, equity financing may be a great place to turn. Unlike with debt financing, a poor credit score can affect your ability to obtain a loan but equity financing offers short term affordability and limited risk.  As there is no loan to repay, the capital obtained can be used solely for business activities without having to be concerned with monthly loan repayments or interest.  No interest to pay	Dilution of ownership and decrease in operational control: not full management of the company. In some cases, dilution of shares means that the company’s percentage of ownership decreases. This may be affected in the case of a company winding up in terms of which shares gain priority.  Share of Company’s profits.  Potential conflict between management as will have to work with others and could result in disputes if there are differences in for example business strategy and management.  No repayment of interest- this is a disadvantage of the private equity firms as they won’t receive interest payments unlike debt financing
Debt financing	Increasing return on investment for a business. Again little use of the owner’s own capital yet making a large return.  The interest payment is tax deductible.  The company does not have to give up ownership of the company and retains full control.  Restrictions on what business owners can and can’t do with the money that they have borrowed. This is good for the lenders to ensure their investment is used wisely.	Higher risk than equity finance if the company is experiencing cash flow problems or financial difficulty as they will still be required to repay the loan.. High interest rates paid on the loans.  Security risks. The lender may want to obtain security by way of for example a charge against business assets or require a personal guarantee from a director of the company which could put them personally at risk. . have priority in insolvency and so they must ensure they have sufficient security/guarantee over this.  May be difficult to obtain a loan if the company has a poor credit rating and has high gearing making it more difficult to obtain future investors.
Equity financing: Angel investment	Similar to equity financing there is limited risk compared to debt finance and is largely easier to obtain particularly for start ups than for example, a loan. The angel investor provides funding in return for equity, as there is no loan to repay, the capital obtained can be used solely for business activities without having to be concerned with monthly loan repayments or interest. No interest to pay The angel investor may be knowledgeable in the company’s industry and therefore could  provide business expertise, which could be extremely valuable for growth. knowledge in the business area of the company.	Angel investors may have high expectations. They might expect the business to make bigger returns, which could lead to pressure on business owners for their business to perform very well.  Loss of control and dilution of ownership as outlined in the section ‘equity finance’.  Share of company’s profits.  As typically angel investors are individuals, the initial sum of investment could be significantly smaller than, for example, venture capital investments.
Equity financing: Venture capital	Hands-on support. Venture capitalists often have valuable knowledge and insight of the business area, and can act as business advisors for the company.  Open to risk. Venture capitalists tend to not resist making a bigger investment if they believe the company has potential. Networking opportunities. There is a good chance that venture capitalists will be well connected within the business sphere which can help the company in the long-run to establish valuable connections.  The money is not a loan and thus does not need to be paid back by the business owner. The venture capitalist provides funding in return for equity.	Venture capitalists have very high standards, and so they will be expecting a good return on their investments. This is a con for business owners as it puts them under more pressure for their company to succeed. Especially as it is very rare for a startup to be backed by venture capitalists.  Dilution of ownership and loss of control. Risk of the company growing too fast. The pressure on startups to grow as quickly as possible to go public or be acquired can harm the business by not developing its services or products to a good enough standard in time.  Can be time consuming and costly to try to obtain.

Terms and definitions: 

Angel investors: These are investors who are capable of investing a large amount of money in a business and are most typically looking to invest in an industry they are familiar with and have experience working in. 

Covenant: a covenant is a promise, agreement, or contract between two parties. As part of the covenant, the two parties agree that certain activities will or will not be carried out.

Dilutions of shares: when a company issues new shares that result in a decrease in existing shareholder’s ownership percentage of that company. 

Debt financing: a financing agreement when the sum of money required to fund the corporate transaction is borrowed from a lending party, who in return will have securities/guarantees on that loan in case of liquidation of the company. 

Equity financing: Equity financing is when a company can raise funds for their business in exchange for shares (equity) in their company.

Venture capitalist funding: when successful investors, financial institutions and/or investment banks finance early-stage companies. 

Author: Eesha Singh -

Author: Eesha Singh -

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DISCLAIMER

This article has been written by law students for the sole purpose of providing informative insight. The information in this article is intended for educational purposes only and does not constitute legal advice, nor should the information be used for the purpose of advising clients. You should seek independent legal advice before relying on any of the information provided in this article.

Sources

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Akhilesh Ganti: “What is Dilution in Trading? Definition and Examples” last updated 18th February 2021, Last Accessed: 15th March 2023 URL<https://www.investopedia.com/terms/d/dilution.asp> 

Murray Newlands: “Pros and Cons of Using an Angle Investor to Fund a Startup” Last Accessed 15th March 2023 URL<https://www.startupgrind.com/blog/pros-and-cons-of-using-an-angel-investor-to-fund-a-startup/>

Maximilian Fleitmann: “Pros and COns of Venture Capitalists: a Complete Guide” Published 26th August 2022, Last Accessed: 15th March 2023 URL<https://www.basetemplates.com/blog/pros-and-cons-of-venture-capitalists>

Adam Hayes: “What is a Covenant? Definition, Meaning, Types, and Examples” Last updated 3rd June 2022, Last Accessed: 15th March 2023 URL<https://www.investopedia.com/terms/c/covenant.asp>