Debt vs. Equity Financing: Which Is Right for You?

Choosing between debt (borrowing) and equity (selling ownership) is one of the biggest decisions you’ll make as a business owner. This guide breaks down both options in simple terms and helps you decide which is right for your situation.

Quick Comparison

Debt Financing Explained

What It Is: You borrow money and promise to pay it back with interest, just like a car loan or mortgage.

Types of Debt Financing

1. Term Loans

• Lump sum upfront
• Fixed monthly payments
• 1-10 year terms
• Example: $100,000 at 8% for 5 years = $2,028/month

2. Lines of Credit

• Borrow as needed
• Pay interest only on what you use
• Revolving (re-borrow as you repay)
• Example: $50,000 approved limit, borrow $10,000 when needed

3. Credit Cards

• Fast and easy
• High interest (15-25%)
• Good for small, short-term needs
• Example: $25,000 limit for business expenses

4. SBA Loans

• Government-backed
• Lower rates and down payments
• Longer terms
• Example: $150,000 at 6.5% for 10 years

Pros of Debt Financing

✅ Keep Full Ownership You own 100% of your company forever. No sharing profits or control.

💡 Example: Your business becomes worth $10 million. It’s ALL yours.

✅ Tax Deductible Interest payments reduce your taxable income.

💡 Example: Pay $10,000 in interest, reduce taxable income by $10,000, save $2,500 in taxes (at 25% rate).

✅ Predictable You know exactly what you’ll pay each month. Easy to budget.

💡 Example: $2,000/month payment. Same amount every month for 5 years.

✅ Relationship Ends Once paid off, you’re done with the lender. No ongoing obligations.

💡 Example: 5-year loan is paid off. Lender has zero claim on your business after that.

✅ No Involvement in Business Lenders don’t tell you how to run your business (usually).

Cons of Debt Financing

⚠️ Must Repay Regardless Even if business fails, you owe the money (especially with personal guarantee).

💡 Example: Business closes. You still owe $50,000. May have to sell personal assets.

⚠️ Monthly Payment Burden Payments due every month, reducing cash flow.

💡 Example: $3,000/month payment. That’s $3,000 less for marketing, inventory, growth.

⚠️ Need Good Credit Typically need 650+ credit score and 2+ years in business.

💡 Example: Credit score 580? Most traditional lenders will deny you.

⚠️ Require Collateral Often need to pledge assets (equipment, property, inventory).

💡 Example: $100,000 loan secured by your $150,000 worth of equipment. Don’t pay? They take equipment.

⚠️ Limits on Future Borrowing Existing debt makes it harder to get more loans.

💡 Example: Already have $100,000 in loans. Banks hesitant to lend more.

Equity Financing Explained

What It Is: Investors give you money in exchange for ownership percentage. They own a piece of your company and share in future profits.

Types of Equity Financing

1. Friends & Family

• $5,000 - $50,000
• Most flexible terms
• People who trust you personally
• Example: Uncle invests $20,000 for 10% ownership

2. Angel Investors

• $25,000 - $500,000
• Wealthy individuals
• Often provide mentorship
• Example: Former entrepreneur invests $200,000 for 20%

3. Venture Capital

• $1M - $50M+
• Professional investors
• Want huge returns (10x+)
• Example: VC firm invests $5M for 25%

4. Crowdfunding

• Many small investors
• $10,000 - $1M
• Also marketing opportunity
• Example: 500 people invest $100-$10,000 each

Pros of Equity Financing

✅ No Repayment Required Money is yours to keep. No monthly payments. No debt.

💡 Example: Get $500,000. Never have to pay it back. Investors share in success/failure.

✅ Share the Risk If business fails, investors lose their money too. You don’t owe anything.

💡 Example: Business fails. Investors lost their $500,000. You move on with no debt.

✅ Get Expertise & Connections Good investors bring advice, industry knowledge, and valuable introductions.

💡 Example: Investor introduces you to major customer. That relationship is worth more than the money.

✅ More Money Available Can raise much more than banks will lend.

💡 Example: Banks might lend $100,000. VCs might invest $5,000,000.

✅ Easier to Qualify Don’t need perfect credit or 2 years in business. They bet on potential.

💡 Example: Just an idea + great team? Can still get angel investment.

Cons of Equity Financing

⚠️ Give Up Ownership Forever That percentage of your company is gone permanently.

💡 Example: Sell 30% now. Business worth $50M later. You gave away $15M!

⚠️ Share All Future Profits Investors get their percentage of profits forever.

💡 Example: Business makes $1M profit/year. Investor owns 20%. They get $200,000/year forever.

⚠️ Loss of Control Investors often want board seats and say in major decisions.

💡 Example: Want to hire a friend? Investor says no. Want to pivot? Need investor approval.

⚠️ Time-Consuming Process Raising equity takes 3-12 months of pitching investors.

💡 Example: 6 months of meetings, pitches, due diligence. Could’ve been growing business instead.

⚠️ Pressure to Grow Fast Investors want returns. They’ll push you to grow quickly, sometimes too quickly.

💡 Example: Investor wants 20% growth per month. You’re comfortable with 10%. Constant pressure.

⚠️ Complex Legal Agreements Term sheets, shareholder agreements, dilution clauses. Need lawyers.

💡 Example: Legal fees of $10,000-$50,000 just to close the deal.

The Decision Framework

Answer these questions honestly:

Question 1: Can Your Business Make Monthly Loan Payments?

If YES → Consider DEBT

Calculate: Annual Revenue ÷ 12 = Monthly Revenue

Can you afford 10-15% of monthly revenue as a loan payment?

💡 Example:

• Monthly revenue: $50,000
• 10-15% = $5,000-$7,500
• Can afford loan payment? YES → Debt might work

If NO → Consider EQUITY

Not enough steady cash flow for monthly payments? Equity doesn’t require payments.

Question 2: How Fast Will Your Business Grow?

Slow & Steady (10-20%/year) → DEBT

• Restaurants, retail, service businesses
• Local businesses
• Traditional industries
• “Lifestyle businesses”

💡 Example: Coffee shop grows 15% annually. Loan is perfect. Keep ownership.

Fast Growth (100%+ per year) → EQUITY

• Tech startups
• Scalable software
• Innovative products
• Potential to be huge ($100M+)

💡 Example: Mobile app growing 30% monthly. Need millions fast. Equity makes sense.

Question 3: How Much Money Do You Need?

$0 - $100,000 → DEBT usually easier

• Banks and SBA will lend this amount
• Don’t need to give up equity
• Faster process

$100,000 - $1M → Could go either way

• Debt: Possible but harder to qualify
• Equity: Small angel rounds
• Often use combination

$1M+ → EQUITY or combination

• Very hard to borrow $1M+
• Venture capital typical at this level
• May use debt + equity combination

Question 4: Do You Want to Keep 100% Ownership?

YES, Keep Ownership → DEBT Even if it’s harder, you maintain control and keep all future profits.

NO, Happy to Share → EQUITY Value advice, connections, and shared risk more than solo ownership.

Question 5: What’s Your Credit Score and Business History?

Good Credit (680+) & 2+ Years in Business → DEBT Available You qualify for traditional financing.

New Business or Lower Credit → EQUITY might be only option Investors care more about potential than past.

Question 6: What Industry Are You In?

DEBT-Friendly Industries:

• Retail stores
• Restaurants
• Professional services
• Construction
• Healthcare practices
• Manufacturing

EQUITY-Friendly Industries:

• Software/Tech
• Biotech
• Consumer apps
• E-commerce (high growth)
• Innovative products
• Platforms/marketplaces

Real-World Decision Examples

Example 1: Sarah’s Bakery

Situation:

• Opening a bakery
• Needs $75,000
• Will make steady profits
• Local business, won’t be huge
• Has good credit (720)

Best Choice: DEBT (SBA Loan)

Why:

• ✅ Can afford monthly payments from bakery sales
• ✅ Local business won’t grow to $50M (no need for VC)
• ✅ Keep 100% ownership and all profits
• ✅ Qualifies for SBA loan with good credit

Result: Gets $75,000 SBA 7(a) loan at 7% for 10 years. Payment: $871/month. Affordable from bakery profits.

Example 2: Mike’s Software Startup

Situation:

• Building a SaaS app
• Needs $500,000
• Won’t make money for 2 years
• Could become huge ($100M+)
• No revenue yet, can’t get loan

Best Choice: EQUITY (Angel/VC)

Why:

• ✅ Can’t afford loan payments (no revenue yet)
• ✅ Banks won’t lend to pre-revenue startup
• ✅ Huge growth potential attracts investors
• ✅ Will need ongoing funding as it grows

Result: Raises $500,000 from angel investors for 25% equity. Uses money to build product, get customers, then raises more later.

Example 3: Jennifer’s E-Commerce Store

Situation:

• Profitable online store
• Needs $200,000 for inventory
• Makes $50,000/month revenue
• Growing 30% annually
• Good credit

Best Choice: COMBINATION

Why:

• ✅ Has revenue for loan payments
• ✅ Growing fast, might need equity later
• ✅ Inventory financing available for debt

Result:

• $100,000 inventory financing (debt) at 9%
• $100,000 from angel investor for 15% equity
• Balanced approach!

Example 4: Tom’s Consulting Firm

Situation:

• Established 5 years
• Needs $30,000 for marketing/hiring
• Steady $40,000/month revenue
• Profitable
• Great credit (760)

Best Choice: DEBT (Line of Credit)

Why:

• ✅ Easy to qualify
• ✅ Keep all ownership
• ✅ Small amount, don’t need equity investor
• ✅ Flexible - only borrow what needed

Result: Gets $50,000 business line of credit. Borrows $30,000 initially. Pays 8% interest only on amount used.

Mixed Strategies: Using Both

Many businesses use BOTH debt and equity at different times!

Common Pattern:

Year 1: Bootstrap + Friends/Family Equity

• Start with savings: $10,000
• Friends/family invest: $20,000 for 20% equity
• Total: $30,000

Year 2: Small Debt (Line of Credit)

• Now have revenue and credit
• Get $25,000 line of credit
• Use for growth

Year 3: Angel Equity Round

• Growing fast, need to scale
• Raise $250,000 from angel for 20% more
• Now 60% owner (you), 20% friends/family, 20% angel

Year 5: Larger Debt Facility

• Established business, strong credit
• Get $500,000 term loan for expansion
• Still own 60%

This is normal! You don’t have to choose one forever.

Key Factors Summary

Choose DEBT if:

• ✅ You have steady, predictable revenue
• ✅ You can afford monthly payments (10-15% of revenue)
• ✅ You want to keep 100% ownership
• ✅ You have good credit (650+) and business history
• ✅ You need less than $250,000
• ✅ Traditional business (not hyper-growth startup)

Choose EQUITY if:

• ✅ No revenue yet or unpredictable revenue
• ✅ Can’t afford monthly loan payments
• ✅ Willing to share ownership for expertise
• ✅ High-growth potential (could be worth $50M+)
• ✅ Need more than $250,000
• ✅ Banks won’t lend to you
• ✅ Want investors’ advice and connections

Use BOTH if:

• ✅ Growing fast but need to preserve equity
• ✅ Want to maximize capital available
• ✅ Different needs (equity for growth, debt for equipment)
• ✅ Reduce risk by diversifying funding sources

Cost Comparison Over 5 Years

Let’s compare the true cost:

Debt: $100,000 Loan at 8% for 5 Years

Monthly Payment: $2,028
Total Paid Over 5 Years: $121,680
Total Cost (Interest): $21,680
Ownership: 100% (yours!)

If business worth $5M in 5 years:

• You own: $5,000,000 ✅

Equity: $100,000 Investment for 20%

Monthly Payment: $0
Immediate Cost: $0
Ownership: 80% (you), 20% (investor)

If business worth $5M in 5 years:

• You own: $4,000,000 (80%)
• Investor owns: $1,000,000 (20%)
• Your “cost”: $1,000,000 in value given up ⚠️

If business worth $50M in 10 years:

• You own: $40,000,000
• Investor owns: $10,000,000
• Your “cost”: $10,000,000 in value ⚠️⚠️⚠️

But Remember: Without the investor’s $100,000, you might not have built a $50M company!

The Hybrid Approach: Convertible Notes

What It Is: Starts as debt, converts to equity later.

How It Works:

1. Investor loans you $100,000
2. You pay low interest (2-5%) or none
3. When you raise equity round later, the debt converts to equity at a discount

Example:

• Get $100,000 convertible note at 20% discount
• Year later, raise equity round at $1M valuation
• Investor’s $100,000 converts as if they paid $800,000 valuation
• They get 12.5% instead of 10% (reward for early risk)

Best For:

• Early-stage startups
• Bridge between rounds
• When valuation is unclear

Common Mistakes to Avoid

Mistake 1: Taking Equity When You Could Get Debt

• Don’t give away 30% when you could get a loan
• Only give equity if debt isn’t available or makes business sense

Mistake 2: Taking Too Much Debt

• Payments you can’t afford will kill your business
• Rule: Loan payment should be < 15% of monthly revenue

Mistake 3: Giving Away Too Much Equity

• Don’t sell 50%+ in early rounds
• You want to own 30-40% after all funding rounds

Mistake 4: Not Considering Combination

• Often best to use both
• Debt for equipment, equity for growth
• Reduces total dilution

Mistake 5: Choosing Based on Ease Alone

• Just because equity investor says yes doesn’t mean it’s right
• Do the math on long-term cost

Your Decision Checklist

Print this and check off:

DEBT Makes Sense If:

• I have consistent monthly revenue
• I can afford 10-15% of revenue as payment
• I have credit score 650+
• I’ve been in business 1+ years (or can personally guarantee)
• I want to keep 100% ownership
• I need less than $250,000
• My business won’t become a billion-dollar company

EQUITY Makes Sense If:

• I have no revenue yet or very unpredictable
• I can’t afford monthly loan payments
• Banks won’t lend to me
• I want investor expertise and connections
• I’m building a high-growth tech/innovative company
• I need more than $250,000
• I’m OK sharing ownership and control

If you checked 4+ in one category, that’s probably your answer!

Next Steps

If You Choose Debt:

• Traditional Business Financing - Learn about loans
• Building Bank Relationships - How to work with lenders
• Cash Flow Basics - Make sure you can afford payments

If You Choose Equity:

• Equity Financing Guide - Deep dive into equity
• How Much Money Do You Need? - Calculate the right amount

If You’re Still Unsure:

• Financing 101 - Review the basics
• Emergency Funding - If you need money fast

Get Professional Advice:

• Talk to a SCORE mentor (free!)
• Consult with a CPA or financial advisor
• Speak with a business attorney for equity deals

Remember: This is one of the most important decisions you’ll make. Take your time, run the numbers, and choose what’s best for YOUR specific situation.

Need help deciding? Visit our contact page for personalized guidance on your financing decision.