Debt financing & Equity financing have their own pros and cons. In this blog, we shall discuss what debt financing and equity financing are and the difference between the two.
When a person leaves the confines of his job and starts his own business, he does every possible thing to take his business to new heights. To run his business smoothly, he works for long hours, travels to long distances, and invests all his savings. However, there comes a time when his funds dry up and he looks for different options to generate finances. In such situations, the best two options that he always looks for are “Debt Financing” and “Equity Financing.”
However, both have their own pros and cons. And at the end, the business owner has to choose the one that would definitely reap him the best results. The blog explains the difference between the two and talks in length about the best option for a business owner.
It is necessary for a business to have enough financial resources if it looks forward to expanding. A business owner can choose to utilize a number of options, including Debt Financing and Equity Financing.
What is Debt Financing?
Debt Financing is essentially a business borrowing money from an outside source on the promise of paying it back with interest. In simple words, it is a business loan which can be secured or unsecured. A firm can take a small business loan either to finance its working capital or acquisition. There are advantages and disadvantages of debt financing but advantages outnumber disadvantages by a significant difference.
The best sources of debt financing are banks, NBFCs, and online lending companies. The important aspect of the debt financing is you are not losing any share in the ownership of the business. There are different types of debt financing, such as machinery loan, working capital loan, flexi business loan, capital loan, and term loan. The major two are secured and unsecured business loans under which all the other types of business loans fall.
The major difference between a secured and unsecured business loan is collateral. While availing a secured business loan, the business owner has to provide a collateral to back the amount taken. Whereas, while availing an unsecured business loan, there is no need to offer any such collateral.
Debt financing is a time-bound activity, the borrower is required to repay the borrowed money with interest at the end of the agreed period of time. A borrower can make payments monthly, half-yearly, or towards the end of the tenure. However, most borrowers choose monthly repayment schedule since it lowers down the amount of EMIs.
What is Equity Finance?
Equity Finance is a process where the business owner sells a share of the enterprise to raise capital for business purpose. There are types of equity financing, such as raising funds from friends or family or going for public offerings. Well, there are pros and cons of equity financing but its major disadvantage is the business owner has to sell a part of the business. This means he cannot take any decisions in future on his own and has to take the consent of his partner.
Debt Financing VS Equity Financing
Which is better for small business owners and SMEs in India? An SME usually looks to avail additional funds when it witnesses an expansion opportunity or to finance working capital. Here, the best option would be to avail a business loan.
The reason for this is, quick business loans for SMEs are available with the advent of technology. The borrower is not required to wait for a long time to get funds. And secondly, there is no ownership dilution.
Now, let us understand the difference between equity financing and debt financing in broader terms.
On one hand, while debt financing is borrowing funds from an outside source with the commitment to repay it (plus interest) later. This includes business loans offered by banks and NBFCs. Here, the borrower makes monthly payments. On the other hand, equity financing, as discussed earlier, is selling individual shares of the business to the investors. The business owner does not have to repay the borrowed funds but he has to give a part of the profits to the investor till the entire life of the business.
The major advantage of debt financing is the lender has no control over the business. And, after the complete payment of the loan, the borrower’s relationship with the lender ends. Another major advantage is the interest paid on the business loan is tax deductible.
Difference between Debt Financing & Equity Financing with Example
Suppose you require a business loan of Rs. 1,00,000 for business expansion. You can either take a loan from an NBFC @ 10% interest or sell a 25% stake in your business for Rs 1,00,000. Assume, your business earns a profit of Rs. 50,000 during the next year.
If you have taken a business loan, your net profit will be Rs. 40,000 after deducting the interest expense. And if you have sold a part of the business, your profits would be Rs. 37,500 (75% of Rs. 50,000) after deducting 25% of the profit which goes to the investor.
The example clearly shows that a business loan is less expensive for you than equity financing. Also, once repaid the loan, there is no relationship between you and the lender whereas the investor will always be a part of your business and have rights over the profit.
How Can ZipLoan help you?
Now that you know that debt is better than equity and how taking a quick business loans for SMEs without collateral is a better option, you might be wondering, how to get a business loan. Well, this is when ZipLoan comes in the picture! ZipLoan is an RBI registered NBFC that makes the business loan process hassle-free for an SME. We offer collateral-free business loans to businesses who cannot provide a collateral. With the help of our technology-enabled platform, we offer business loans online. We believe in providing the best financial solutions to your business.