What’s the difference between equity and debt?
Understanding the Types of Securities
There are two types of financial offerings available to entrepreneurs, equity and debt. In exchange for private equity investments, the venture issues equity securities. There are three basic types of securities.
- Common shares are most often issued to those who manage the corporation, bear the major risks of the venture, and yet stand to profit the most if it is successful.
- Preferred shares have liquidation and dividend preferences over common shares and may be converted into another class of shares, usually common shares.
- Debentures are long-term, unsecured debt securities.
Debt financing is a method involving an interest-bearing instrument, usually thought of as a loan, and it requires that some asset be used as collateral. Debt requires the venture to pay back the amount of the borrowed funds as well as a fee for the use of the money for the time it was loaned out, which is called interest.
All entrepreneurs interested in raising capital must decide which vehicle is most appropriate for their situation. An equity offering will give share ownership and some level of control to others. Also, with an equity offering, working capital and financial leverage of the venture improves, as interest costs and debt service in future years are avoided.
On the other hand, debt financing has the distinct advantage that it does not dilute the existing shareholder value. While the main focus of our discussion is on private equity financings, the process and information required—like the business plan, marketing plan, and financials—are very similar to what is required for debt financings.