Business Loan vs Equity Financing: Which one is better for your business?
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Business Loan vs Equity Financing: There comes a juncture in the journey of each business that their financial capability is not in synchronisation with their aspirations. It is at that moment they find themselves perplexed about whether to mobilise the required capital by taking a loan, or by issuing equity.
To understand how Business Loans and Equity Financing are different from each other and which one would be suitable for you, we’ve succinctly explained the two, their advantages and disadvantages, the key differences, as well as the points you must keep in mind before opting for either.
What is a Business Loan?
A business loan is a sum of money that a Financial Institution (Banks/NBFCs) lends to a business for a specific tenure at a specified interest rate and mode of repayment.
A business loan could either be given against collateral (secured) or without collateral (unsecured). Financial Institutions usually charge a higher interest rate for loans that are unsecured since they are exposed to comparatively higher risk. A business loan is a part of the Debt Financing mode of raising capital.
The entity providing a business loan becomes a financial creditor of the business, while the amount raised through a business loan is a liability for the business till it is fully repaid (along with the interest).
A business loan is opted for by businesses that do not wish to alter the ownership structure of the company or its management. Once the loan is repaid, the relationship between the lender and the borrower terminates.
Advantages and Disadvantages of a Business Loan
A business loan may have various advantages and disadvantages depending upon the type of debt instrument used for a business loan. For example, while an Overdraft Facility may have the advantage of paying as per convenience, the same advantage may not be available for business term loans.
However, the following are the advantages and disadvantages that are applicable to almost all types of business loans, when compared with equity financing-
Advantages
- Does not change the ownership structure– A business loan does not alter the shareholding pattern of an enterprise. The capital raised through a business loan makes the lender a financial creditor of the enterprise and the relationship between the enterprise and the lender ends when the loan is repaid.
- No involvement in business operations– Merely taking a loan does not allow the creditor to influence the operations of the enterprise and allows the management to function as they deem fit.
- Tax benefits– The interest paid on a business loan is tax deductible. Hence, it decreases the tax liability an enterprise has.
Also Read: Business Loan Tax Benefits
Disadvantages
- Interest payments– As opposed to equity financing which does not require any interest payment to the investor, a business loan is given at a specified interest rate that constitutes the profit of the lender.
- A good credit score is a requirement– A good credit score is a prerequisite to getting a business loan. In case the credit score of an enterprise is not good, the lender may put forth a higher interest rate and stricter conditions for a loan.
- Puts a burden on cash flow– Interest payments increase the revenue expenditure of an enterprise which may put a burden on the borrower’s cash flow.
- Risk of default and loss of an asset– If the enterprise is unable to repay its loan on time, it may lead to a default. In case the loan is backed by collateral, the lender then may seize the asset to recover the outstanding amount.
Also Read: Secured vs Unsecured Business Loan: Know Differences [2024]
What is Equity Financing?
Equity Financing is a way enterprises raise capital by diluting the shareholding pattern of the organisation. The organisation in such cases offers a stake in the company in the form of shares, that could be bought by investors to gain promoter rights proportional to the amount invested.
An enterprise can raise capital through equity financing in the following ways-
- Initial Public Offering (IPO)– A company could choose to issue a certain stake in the company through the stock market by allowing the public to buy shares of the said company.
- Follow-on Public Offer (FPO)– In case a company already listed on the stock exchanges wishes to raise capital through equity financing, it could issue additional shares to be traded on exchanges. This would further increase the shareholding of the public in the company.
- Venture Capitalists/VC Firms– Venture capitalists scout for companies with high growth potential to invest in. VC firms usually invest in businesses in the early phases to reap benefits upon their IPOs.
- Angel Investors– Angel Investors invest in small businesses against a considerable stake in the company and serve as a guide/mentor as well.
Advantages and Disadvantages of Equity Financing
Equity Financing as a means of raising capital has several advantages as well as disadvantages, some of which include-
Advantages
- No obligation of repayment– The capital raised through Equity Financing does not have to be paid back, unlike a loan.
- No interest levied on the capital– No interest is levied on the capital raised through equity financing. While dividends can be distributed to shareholders of a company, it is not mandatory and is at the discretion of the company.
- Expert advice and guidance– Angel Investors usually guide small businesses and bring in their technical knowledge since they are invested in the company and its well-being would ensure an increase in the investor’s wealth.
Also Read: Best 30+ Business Ideas for Women Entrepreneurs in India
Disadvantages
- Dilution in the ownership structure– Capital raised through equity financing changes the ownership structure of the enterprise and may even make the erstwhile promoters minority stakeholders.
- Interference in management– The inventors may interfere in the day-to-day functioning of the enterprise or try to influence the operations and strategy of the organisation.
- Takes a lot of time to find investors– It may not be easy to find an investor willing to provide capital and thus, takes a considerable amount of time when compared with finding lenders for a business loan.
Business Loan vs Equity Financing: Which One to Choose for your Business?
While both business loans and equity financing are means to raise capital for a business, they have various differences in terms of how that capital affects the business.
| Business Loan | Equity Financing |
| The lender becomes a Financial Creditor. | The investor becomes an Owner. |
| The capital raised must be repaid within the tenure of the loan. | The capital raised is not repaid, except in the case of liquidation of the company. |
| Interest is levied on the outstanding loan amount. | No interest is levied on the investment amount. |
| Can affect your credit score. | Does not affect your credit score. |
| No interference in operations. | The investors may interfere in the operations of the business. |
| Interest paid on business loans decreases the tax liability. | No tax benefits on capital raised through equity financing. |
| No guidance provided by the lenders. | Guidance and advice provided by investors. |
Check For Other Loan Options-
Should you go for a Business Loan or Equity Financing?
The apposite option for your business to raise capital must be the one that helps you in realising your goals at minimal cost and interference. Thus, your decision must be based upon the following criteria-
- Business Vintage– The number of years of existence has a role to play in choosing the right financing means. While Banks/NBFCs hesitate to give loans to new businesses and offer loans at higher interest rates, Venture Capitalists scout for start-ups and new businesses. Thus, loans might be harder to get than equity financing if your business is new or does not have anything substantial to show.
- Business control– Equity Financing may entail interference of the investors in the operations of the business. Thus, if one wants to avoid that, a business loan would be a better option to raise capital.
- Technical advice/Guidance– Since no guidance or technical advice is provided by creditors to the borrower, raising capital through equity might come a little handy if the business is new and seeks the guidance of an expert.
- Share in profits– You may have to share your business profits with the investor if opted for Equity Financing as a means to raise capital. Since business loans make the lender a creditor and not a shareholder, they are not entitled to a share in profits.
- Tax benefits– You may lose upon tax benefits if you go for equity financing instead of a loan. The savings over time could be considerable considering that the taxable income gets decreased by opting for loans.
- Consistency in Income– In case the income of the business is inconsistent, paying interest on a loan could be difficult and may lead to a default. In such a case, the credit score of the business deteriorates, further decreasing its chances to get a loan. In such cases, mobilising capital through equity is more suitable as the investors may be accommodative and invest in a company even if it is running at a loss. A business should thus weigh these parameters before selecting the option more suitable for capital mobilisation.
FAQs
What is the difference between equity financing and loans?
The primary difference between equity financing and loans is that capital is raised by issuing shares in equity financing, while capital is raised by borrowing when it comes to loans. Equity financing alters the shareholding pattern of the firm, while the shareholding pattern is not affected by raising capital through loans.
Which is better, debt or equity financing?
Equity financing is better option of raising capital in case the business is new and does not have consistent income, while debt is certainly the better option if the business is well established and the promoters do not want to alter the shareholding pattern of the enterprise.
Is equity cheaper than a loan?
A loan is usually cheaper than equity if one takes into account the tax savings one derives from a loan, as well as the fact that a business does not have to share its profits with the lender. Raising capital through equity changes the shareholding pattern of an organisation and the investor becomes entitled to the profits of the organisation proportional to their capital investment.
What are three sources of equity financing?
The following are the sources of equity financing-
- Stock Exchanges– Shares are issued on stock exchanges.
- Crowdfunding– Capital is raised by issuing shares to several investors.
- Angel Investors– HNIs (High Net-Worth Individuals) invest in businesses to increase their wealth.
- Venture Capital Firms– VC Firms invest in high-growth companies to derive higher gains from their investment.
Which is riskier, debt or equity?
From the point of view of the investor, equity has a higher risk as the business may fail in the future and close down. In such cases, the investor may have to incur a loss. A debt in comparison makes the investor a creditor and ensures that the investor is paid back before the shareholders.
From the point of view of businesses, there is no mandate to pay dividends on equity and thus has no risk of default. However, they would have to part ways with a share in their profits and a stake in the company.
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