All businesses need cash to operate. Sometimes a business may need outside financing for buying a new piece of equipment, research and development, buying inventory, or adding sales and marketing capacity. There are two ways to finance the capital of a business: The business can borrow money, called “debt financing,” or the business can sell part of its ownership to an investor, called “equity financing.”
Debt financing is usually less expensive than equity financing because the business has made the lender a promise to pay the money back with interest. The lender may require that debt be secured by collateral or personally guaranteed by the owners of the business. A business loan from a bank is a common type of debt financing.
If debt financing is not an option or not desired, the business may elect instead to raise capital by selling a portion of its equity. In a corporation, the equity is referred to as stock; in an LLC, it is referred to as a membership interest.
Comparatively speaking, equity is riskier than debt because debt is paid ahead of equity in the event of a sale or liquidation. However, equity enjoys a bigger potential upside if things go well in return.
In addition, there are hybrid approaches, such as convertible debt, which is treated as debt initially but also offers the holder the option of converting the principal and accrued interest into equity in the future under certain circumstances.
There is no one right or wrong answer when it comes to choosing debt or equity financing. Rather, a company must consider a range of factors, which might include the company’s operating history, prospects and collateral, as well as the proposed use of the funds, available options and proposed terms.