Debt vs equity finance: which is right for your business?

But don’t worry... the decision is much easier (and more likely to be successful) once you understand your options. And in this article, we’ll help you do just that.

Read on to discover which financing option best suits your specific business goals and circumstances. 

Key points

• Equity financing trades ownership for capital, while debt financing maintains full control but requires interest repayments

• Your business stage, financial health, governance preferences and market conditions can all influence the financing option that’s most suitable for you

• Funding Options by Tide can help you find the right business finance solution with free eligibility checks and access to loans up to £20 million

What is equity and debt finance?

When you’re looking to grow your business, you’ll typically have two main financing options – equity and debt.

• Equity financing: Involves selling a share of your business to investors in exchange for capital. You won’t need to repay this money, but the investor(s) will become part-owners of your business. Angel investors, venture capital firms, private equity, and crowdfunding platforms can provide equity finance.

• Debt financing: Involves borrowing money (usually from a bank) and paying it back with interest. This could be a term loan, asset finance, invoice finance, or a business credit card. Unlike equity, debt financing doesn’t dilute your ownership. You’ll retain full control of your business as long as you keep up with the repayments.

Which option is right for your business? The answer isn’t always straightforward, and it will depend on factors such as your business’s stage of development, financial health, governance preferences, and the current market environment.

Making the right choice for your business

Choosing between equity and debt financing will depend on your unique goals and the specific circumstances of your business.

Growth stage

If you run an early-stage business, you might struggle to secure debt financing due to limited trading history and assets – this is perhaps why just 3.5% of UK SME’s apply for borrowing. But what younger businesses do have is plenty of growth potential, which can make equity finance the more viable option.

If your business is further along, with a proven trading history and ownership of valuable assets (eg cash, warehouse stock or equipment) your options are more flexible. Equity might be more suitable if you’re growing quickly, and debt could be a better choice if you’re generating regular revenue.

Financial health

The current financial position of your business will have a big impact on the type of financing option that’s most suitable for you.

If your business is showing predictable revenue growth and has strong margins, debt financing might be the more attractive option since you won’t have to give away part of your equity.

If you’re not generating consistent revenue, the choice is more nuanced. If you can at least demonstrate predictable growth, you could raise money by selling equity. But if not, it may still be possible to take out a loan if you can demonstrate (via a business plan) that you won’t spend a large portion of the money until you’re generating consistent revenue.

You’ll also want to consider your risk appetite – are you comfortable taking on higher levels of debt? Or would you prefer sharing the risk with an investor?

Governance process

Taking on equity financing can impact the decision-making process within your business. Depending on how much equity you sell and the appetite of your investor(s) to be involved with business strategy, you may find that you lose some autonomy over your decisions. This may be worth it if the investor brings relevant experience, but could prove a hindrance if they have a different vision for your business.

Whether you’re taking on equity or debt finance, be prepared for different reporting requirements. Equity investors often want detailed business updates and board seats, while lenders will be more interested in your financials and whether you’re making repayments on time.

Also consider your long-term plans. If you want to keep the business in the family, for example, debt finance might be a more suitable choice. If you want to sell your business or list it on the stock market, taking on experienced investors for equity could prove helpful.

Market factors

External factors like the broader economy and specific industry trends can significantly influence the options that are available to you.

When the economy’s uncertain, or going through a ‘down’ period, you may find it harder to secure equity financing while experienced investors wait to see how things pan out.

The specific sector your business operates in matters too. You’ll need to think about things like whether your business needs some upfront investment to operate (which debt can help finance) or if you’re operating in a crowded market (which may prove more difficult to find interested investors).

Interest rates will also impact the viability of taking on debt. Clearly, businesses typically prefer to take on low-interest debt than high. But it’s impossible to predict future interest rates, which can make the decision to borrow now or later tricky.

Creative financing approaches

Depending on your business goals and circumstances, you may find that choosing equity or debt finance isn’t quite right. For example, you might need capital without diluting your ownership too much, or you might need funding that traditional lenders consider too risky.

Fortunately, there are plenty of options you might find more suitable.

Hybrid finance

Equity and debt aren’t the only options when it comes to financing business growth.

• Mezzanine finance: Usually, your business needs to own assets to take out a loan so that the lender can sell your assets to pay back the loan if you don’t have the cash. Mezzanine finance allows you to borrow money without assets. You’ll usually have to pay a higher interest rate, and if you can’t afford to pay back the loan, then you’ll have to give away some equity instead. Essentially, it’s using your equity as an asset to borrow money you’d otherwise be unable to.

• Convertible loan note: This is a type of loan that can turn into equity in your company later on. It allows you to borrow money now, but instead of paying it back, the lender has the option of receiving equity in your business when you raise your next round of investment. The lender will typically get a discount on the share price as a reward for investing early. Convertible loan notes can be a good option when you’re not sure what your business is worth but you need finance quickly.

• Revenue-based financing: If your business isn’t generating predictable revenue (eg sales are seasonal), you can get a special type of loan that lets you pay it off based on a percentage of your monthly sales rather than a fixed repayment amount. You’ll have to pay a fee for this privilege, but it means you can pay off more of the debt when times are good and less when things are slower.

Strategic use of equity and debt

If you don’t want to put all your eggs in one proverbial basket, you can leverage equity and debt at the same time. For example, you might want to use equity finance to fund a new high-risk project (entering a new market, for example) and use debt for projects that you’re confident will generate revenue quickly (eg expanding warehouse capacity).

Your financing needs will change over time to support your business as it grows. You might get started with personal savings and support from friends and family. Then, you might raise equity finance from angel investors and venture capitalists. And finally, when your business is generating stable revenue, you might take on debt to secure loans. Using these options strategically can help give your business the flexibility to adapt to new opportunities and optimise the ownership structure.

Often, getting one type of funding can help you access another. For example, having experienced investors can give lenders confidence that you’ll be able to repay a loan. And having a track record of paying off debt can show investors that you’re financially responsible. Similarly, you can use debt to cover costs between investment rounds, or use investor money to pay off expensive debts.

Debt-to-equity ratios

Different businesses can manage different levels of debt. Tech companies, for example, often have less debt because they don’t own many assets and have less predictable revenue. Retail businesses, on the other hand, often have more debt because they have valuable stock and property that can be sold if needed. This is why tech companies tend to raise equity finance while retail businesses prefer debt finance – they choose the right financing option for their business.

The debt-to-equity ratio of your business will naturally change over time. It may start with almost 100% equity funding, then gradually take on debt as revenue becomes more predictable. But it’s important to watch for signs that your debt-to-equity ratio is becoming unbalanced (eg if you’re struggling to make loan repayments or passing on investment opportunities because you can’t finance them).

To make sure your business maintains a healthy level of debt and/or equity, avoid types of financing that don’t match your business stage and always keep a financial buffer for when things (inevitably) don’t go exactly as planned.

How to secure equity and debt financing

Once you've decided which type of financing is right for your business, you’ll need to prepare well to maximise your chances of success.

Preparing for equity financing

During the 2010s, investors typically looked for businesses that had plenty of growth potential. But in the 2020s, their focus has shifted to investing in businesses that understand their financial fundamentals and have a clear path to profitability.

If you’re looking for equity financing, you’ll need to convince investors that your business can succeed amongst its competitors and show an evidence-based growth strategy.

✔ Research investors who’ve funded similar businesses to yours

✔ Get introductions to investors from mutual connections instead of cold-emailing

✔ Start building investor relationships 6-12 months before you need the money

✔ Clearly explain how you’re different from your competitors

✔ Show in your pitch deck how your product or service solves real customer problems

✔ Prove you’re using money efficiently to grow your business (eg streamlined operations and effective marketing)

✔ Send regular updates to interested investors showing your progress

✔ Use feedback from early conversations to improve your funding proposal

Ultimately, your business should demonstrate sustainable growth potential and efficient use of capital to attract suitable investors. Bear in mind that equity investors are particularly wary of unrealistic market predictions and overly optimistic growth forecasts without supporting evidence.

Showing good management, transparency and responsiveness throughout the process is just as important as your formal pitch.

Preparing for debt financing

Similarly to investors, lenders have also become more cautious over recent years and are now focusing on a business’ ability to generate consistent cash flow.

With interest rates much higher than during the previous decade, lenders want to see that your business can afford the monthly loan repayments even if things don’t go perfectly to plan.

✔ Identify the exact amount you need to borrow and the type of loan that best suits your situation

✔ Show you can generate enough cash to comfortably make loan repayments

✔ Prepare three years of financial statements, current accounts, and future forecasts

✔ Include “what-if” scenarios in your plans showing you can repay loans even if things don’t go as planned

✔ Explain how the loan will benefit your business (eg “This equipment will increase efficiency by 30%”)

✔ Fix any credit issues and make sure your Companies House filings are up to date

✔ Maintain good payment records with suppliers and existing lenders

✔ Consider taking a small loan first to build a track record before asking for bigger amounts

Lenders are inherently cautious, so be prepared to address any parts of your business history that could be of concern.

For more complex loans, such as mezzanine finance (mentioned earlier), you can often improve your chances of success and secure more favourable terms by getting professional advice.

Find business finance with Funding Options by Tide

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Checking if you’re eligible is free, only takes a few minutes, and while a full application would impact your personal or business credit score, checking eligibility won’t. Just submit your details via the link below to find out if you could be eligible to borrow up to £20 million. 

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FAQs

At what stage of business development is equity financing typically more advantageous than debt?

Equity financing could work best for your business if it’s in its early stages, when cash flow is unpredictable and you can’t reliably make regular loan repayments. If you’re working on an innovation that takes a long time to develop but has huge market potential, equity investors are more likely to share this journey with you.

That said, it really depends on the type of business you run – a software startup might not need much initial capital and could grow without external funding, while a manufacturing startup might benefit from raising debt finance for equipment, holding on to equity in exchange for working capital and growth.

What are the hidden costs of equity versus debt that businesses often overlook?

With equity, you’ll need to spend a lot of time managing your investor relationships. This will often include preparing and attending board meetings, sending detailed reports and responding to enquiries. This can eat into your daily schedule, especially if you run a small business.

With debt, there are other costs beyond repayments – arrangement fees, monitoring charges and early repayment penalties (if you use them) can all add up. Restrictions that come with some loan agreements could even cost your business more than the interest itself, particularly if you need to change direction quickly but can’t because of certain conditions of the loan.

How does my industry sector affect which funding option is more suitable?

Your industry plays a big role in influencing the types of funding options that make the most sense. For example, if your business operates in the manufacturing sector and uses lots of machinery, you’ll have physical assets to secure loans against. But if you’re in the tech sector and have few physical assets, equity funding usually fits better.

If your business earns stable revenue regardless of what the economy’s doing (eg healthcare or essential consumer goods), you could get better debt terms than businesses that rise and fall with the economic tide.

What minimum requirements do businesses typically need to meet for each funding type?

If you’re thinking about debt financing, your lender will typically want to see at least two years of trading history and enough monthly revenue to comfortably cover loan repayments. If you run a small business, you might also need to provide a personal guarantee.

For equity, it varies depending on the stage of your business. Angel investors will want to see proof that your concept works and early market validation, even if you’re yet to make money. Venture capital firms will want to see regular revenue and a good rate of growth. And later-stage investors will be more interested in your path to profitability.

How can businesses effectively combine debt and equity financing for optimal results?

Depending on your needs, you may want to consider using different types of financing for different reasons.

• Equity: Can be suitable for riskier activities like developing new products or entering new markets.

• Debt: Can be suitable for funding the purchase of specific assets or to bridge gaps in revenue.

Businesses often start with equity finance to help prove their concept and start to scale, then take on debt once their revenue becomes more reliable. Using this approach enables you to give away less of your business equity early on while also taking advantage of better loan terms as your business grows stronger.

What impact does taking on external funding have on day-to-day business operations and decision-making?

Taking on external funding can change how you run your business. In all cases, taking on funding will require you to conduct more rigorous financial reporting and forecasting. This naturally involves more work but it can also help improve how you run your business.

With debt specifically, lenders may regularly check that you’re meeting the terms of your loan. And they could restrict big decisions like acquisitions or significant changes in strategy.

Equity investors will typically have more say in the strategic direction of your business, especially if they have a seat on your board. On the one hand, this can give you valuable expertise, but it could also create tension if your visions aren’t aligned.

How does the economic climate affect the equity vs. debt decision?

The economy can have a big impact on the viability of debt and equity financing.

• When the economy’s doing well: Loans are generally easier to get and offer more competitive terms – which can be an attractive option if your business has stable cash flow. Equity valuations also tend to rise, meaning you might need to give away less of your company for the same amount of money.

• During downturns: Loans become harder to get (particularly for riskier businesses) and the terms become less competitive. There’s usually less equity being invested, and investors that are still active often price businesses at lower valuations.

And of course, interest rates directly affect how affordable debt is.

What are the typical timelines and success rates for securing equity versus debt financing?

If you’re looking for a loan, you can generally expect decisions to be made more quickly than with equity (assuming you run an established business). And you’ll have a much higher chance of securing a loan than investment.

• Debt: Bank loans can be secured in as little as a few weeks, with around 70% of businesses getting approved.

• Equity: Angel investment typically takes 2-6 months, with an average success rate of just 2.5%. Venture capital can take around 6 months, with an even lower success rate of just 1% of businesses securing funding.

To improve your chances and speed up the process, consider working with an experienced business or financial advisor, and make sure your paperwork is prepared in advance.

Please note that the information above is not intended to be financial advice. You should seek independent financial advice before making any decisions about your financial future.

It’s important to remember that all loans and credit agreements come with risks. These risks include non-payment and late-payment of the agreed repayment plan, which could affect your business credit score and impact your ability to find future funding. Always read the terms and conditions of every loan or credit agreement before you proceed. Contact us for support if you ever face difficulties making your repayments.

Funding Options, now part of Tide, helps UK firms access business finance, working directly with businesses and their trusted advisors. Funding Options are a credit broker and do not provide loans directly. All finance and quotes are subject to status and income. Applicants must be aged 18 and over and terms and conditions apply. Guarantees and Indemnities may be required. Funding Options can introduce applicants to a number of providers based on the applicants' circumstances and creditworthiness. Funding Options will receive a commission or finder’s fee for effecting such finance introductions.