Equity financing is an investment in the ownership of the company. Equity can come from your own resources, from family, friends, employees, and customers, or from outside investors, including venture capitalists who seek to buy into businesses that have the potential for growth. Equity investors are generally given a portion of ownership (and control) of the company; looking at it from the point of view of the founder, accepting equity financing from others reduces the percentage of the company that you own and control.
Debt financing is a loan, a liability to the company (and, depending on the form of the business, also to the owner). Sources include banks, commercial lenders, and government agencies, including the U.S. Small Business Administration.
Loans can be used for ongoing operations, for the purchase of equipment, and for short-term uses such as inventory.
Outside investors will usually be very interested in determining and assessing your company’s debt-to-equity ratio. That formula compares the money you have borrowed, or plan to borrow, to the amount of your own money you have invested in the business. The more money the owner and partners or shareholders have put into the business, the more comfortable an outside lender is likely to be with a request for a loan.
Think of the parallel in buying a home. Most lenders are much more willing to issue a mortgage to a borrower who puts a substantial down payment into the home. The theory is that an owner who is risking some of his or her own money is a more dedicated and trustworthy borrower than someone who is working entirely with other people’s money.