If you are seeking financing to start your new business, it's important to understand the difference between the two basic types of financing: debt and equity. Here's a closer look.

Debt financing is the type of financing that most of us are already familiar with from daily life. When you take out a home mortgage loan, obtain a loan to buy a car, or purchase something using a credit card, you are using a form of debt financing. Basically, debt financing means an individual or organization is lending you money that you must pay back with interest at a future date.

Equity financing is an investment, rather than a loan. In equity financing, an individual or organization gives you money in return for a share of ownership in your business. Equity financing may come from a variety of sources, including individual investors, venture capital firms, or even the general public if you take your business public and begin selling stock in your company. However, at the startup stage, equity financing will typically come from individuals such as your friends and family or angel investors.

Here are some of the pros and cons of equity financing.

  • Pro: You will not have immediate loan payments to make, which is helpful for a business startup that needs to conserve its existing capital.
  • Con: Obtaining equity financing requires giving up a share of your business. Even if you still own the majority of the company, you will have to answer to investors who expect a return on their investment.
  • Pro: In addition to capital, equity investors often bring experience, connections and know-how that can help your startup grow.
  • Con: In a worst-case scenario, equity financing could ultimately result in you losing control of your business and being ousted by investors who don't agree with how you are running things.
  • Con: Equity capital is not open to all types of businesses. Investors typically seek a good return on their investment, which means they are more likely to finance businesses in high-growth industries such as technology or healthcare and than to finance "Main Street" businesses.

Here are some of the pros and cons of debt financing.

  • Pro: Once the loan is paid off, you are free and clear of any obligation to the lender, and the lender has no control over how you run your business.
  • Con: When you take on debt financing, you will immediately owe regular payments, which can range from daily payments to monthly payments depending on the type of loan. This will take away from the available capital you have to run your business.
  • Pro: Debt financing is available in a wide variety of forms, including short and long-term loans, inventory and equipment loans, accounts receivable loans, guaranteed loans and even personal loans.
  • Con: If you fail to pay back the loan, or make late payments, it can hurt your business and/or personal credit rating, making it more difficult to get financing in the future. If you have put up collateral for the loan, you may lose your collateral.
  • Pro: Successfully paying off your loan will build your business credit rating and can make it easier to get loans or credit in the future.

Before deciding whether debtor equity financing is right for you, carefully consider:

  • How much control you are comfortable giving up to outsiders
  • How confident you are in your financial projections and your ability to rapidly make a profit
  • Whether you need advice and guidance in starting your business, or simply need capital

A SCORE mentor can help you decide which type of financing is best for your business and guide you to possible sources of both debt and equity capital.

Startup Financing Basics: Debt vs. Equity