Why Is Equity More Expensive Than Debt?

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When raising money for a business venture, you can choose to sell a share of ownership in the company or borrow money. While using equity can be very attractive because you do not have to make loan payments, it can actually be much more expensive than debt in the long run.

Debt vs. Equity

  • Both debt and equity are legitimate ways to finance a new business and each business sees things differently when it comes to getting money. Some would prefer to simply borrow the money from a commercial lender and then make loan payments until the debt is gone. Others would prefer to bring on investors so that they are not tied down with paying back a loan while cash is tight. When you use equity financing, you will have to share profits with the investors in the future.

Fixed Time vs. Permanent

  • One of the big differences between financing with equity and debt is the time frame involved. When you borrow money from a lender, the lender is entitled to regular payments for a certain amount of time. After that time is up, you no longer have to make your debt payments and you can keep all of the profit from your company. By comparison, when you use equity to finance, the shareholder is entitled to a percentage of the profits for the life of your company.

Assets vs. Earnings

  • These two methods have claims against different items in your business. When you borrow money from a lender, the lender typically gets a claim against the company's assets until the debt is paid off. The debt is essentially secured with collateral. When you finance a company with equity, the investor instead has a claim on the earnings of the company. When a profit is generated, the company is expected to divide up some of the profit with the shareholders.

Cost vs. Risk

  • Although equity can be more expensive, you have to consider the risk to your business. If you are in a business that may not generate a profit for a certain amount of time after you open, going with equity can still make some sense. Even though you will have to give up a portion of your profits for the rest of the business's life, you can still stay in business and earn profit. If you use debt, you are always at risk of having the lender take your collateral if you cannot afford to make payments.

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