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Debt vs. Equity: Choosing the Right Mix for Your Startup in India

Rewati Krishnan
Setindiabiz Team |inUpdated : January 21, 2025

Starting a business is exciting but challenging too, especially when it comes to capital or funds to run its operations smoothly. Most entrepreneurs or startup founders are confused in choosing between the debt and equity financing, or finding the right mix. This blog discusses these two available modes of financing in detail to help you decide the right course of action for your business in this diverse and dynamic Indian market.

Debt Financing

Debt means the amount of money borrowed from a lender that is required to be repaid and financing means providing funds to be used in business activities. The key feature of debt financing is the fact that there is no chance of losing ownership in this option. It is a time-bound activity where the borrower has to repay the debt/loan amount with its interest at the end of the period the involved parties agreed upon. The borrower commonly could make payments on monthly, quarterly, half yearly, or at the end of the loan tenure as described while sanctioning the loan.

In debt financing, the loan is secured or collateralized with the assets of the company which is the applicant. It's commonly a secured loan. In case the loan is unsecured, the line of credit is usually less. This financing option is used in circumstances where a company needs a big loan by attaching some of the company's assets and as per their valuation the loan is given.

Advantages of Debt Financing

1. Maintain Company Ownership

The main purpose of companies behind preferring this option over equity is to preserve ownership of the company. In equity financing, some common shares are given to the investor in exchange of funding. As a result, the investor gains shareholder voting rights since ownership rights are shared.

While, in case of a Debt capital, lenders provide this capital and are entitled only to their repayment of capital along with the interest levied. Therefore, by availing this form of financing, no changes occur in the original ownership of the business owners as they are no more obliged to the lender once the debt is paid off with the interest.

2. Tax-deductible Interest Payments

The other crucial feature of debt financing is that the interest paid on the debt or loan is an expense for the borrower and is tax-deductible. Due to which, it reduces the company's tax obligations. The principal payment and interest expense are fixed, and hence, it is assumed that the loan is paid at a constant rate. As a result, it allows for accurate forecasting, making budgeting and financial planning easier.

Disadvantages of Debt Financing

Need for Regular Income

Repayment of debts can be quite challenging for some business owners. To ensure timely payment of their debt installment, the business owners must be capable enough to make good earnings or profit from their business. There are also many lending institutions that require the assets of the businesses as collateral for giving debt/loan as the assets kept as collateral can be seized if the business is unable to make certain payments.

Adverse Impact on Business Goodwill

In case the borrowers don't have a solid strategy to repay the loan they have taken for their business, they will have to pay the consequences. In case of late or missed payment of instalments, the credibility of the business can be affected adversely, and such businesses will have to face difficulty in borrowing loans or debt in the future.

Potential Bankruptcy

The business owners often put their business at risk of bankruptcy by providing its assets as collateral for taking any debt/loan. By doing so, the business becomes obliged to repay the loan even if it has failed or not making sufficient profit to repay it.

Equity Financing

Equity Finance refers to the sale of company shares to raise capital. In other words, it is the process of raising funds in exchange for the sale of equity instruments such as common stock, preferred shares, share warrants, etc.

Advantages of Equity Financing

Alternative Funding Source

The primary advantage of equity financing is that it gives companies an alternative funding source to raise capital. Even the startups that don't qualify for large loans from banks can seek funding from other reliable sources like angel investors, venture capitalists or crowdfunding options. Equity financing is viewed as relatively less risky as the company doesn't need to repay it.

The best part is that such investors are not in a hurry of making instant returns as they invest for long-term returns so the company has no pressure of providing them early returns and thus can invest the capital for the substantial growth of the business.

Access to business network, management expertise and other capital sources

Along with raising capital for the business, this fundraising option also provides other benefits to the company. Some self-motivated investors love to be part of the company operations they are investing in and like to contribute to the growth of the company. Due to their active involvement and vast experience, they can benefit the company with their authentic business network, management expertise, and access to other capital sources. Many angel investors or venture capitalists assist companies with their expertise that is so crucial for the startups as well as established businesses looking to upgrade themselves.

Disadvantages of Equity Financing

1. Dilution of ownership and operational control

When it comes to the disadvantages of equity financing, the major disadvantage is that company owners have to lose a portion of their ownership and dilute their control. If the business makes a significant profit and succeeds in the future, a certain percentage of company profits must also be given to shareholders as dividends.

Most investors or venture capitalists demand a higher equity stake that may go upto around 30-50%, especially for startups lacking a robust financial background. However, many company founders/owners don't want to dilute such an amount of their corporate power, thereby limiting their equity financing options.

2. Lack of tax shields

Equity investments have no tax shield. Dividends distributed among shareholders are not tax-deductible expenses; in contrast, interest payments are eligible for tax benefits. Equity financing is considered to be a more expensive financing form than debt in the long term. Investors often expect a higher rate of return than lenders. The reason is that investors incur a high risk of funding startups, so they expect a higher return.

Debt vs. Equity : Key Differences

Debt FinanceEquity Finance
OwnershipThe company retains full ownership of the business.The lender becomes investors and in equity financing the investors receive some of the business shares in exchange of capital they invest.
Repayment The company or business must repay the debt, loan plus interest within a predefined financing term. Whether a business makes profit or not, it won't impact the repayment obligation.Investors are not entitled to repayment of their investment until the company is sold or liquidated.
Risk Debt finance is considered to be less risky than equity finance because the company doesn't have to dilute its ownership. If the company assets are kept as collateral, the lender will sell such assets to levy its loan.It is considered to be riskier than debt finance, because investors are allotted shares of the business they are giving loan or debt.

How to Choose the Right Mix?

Choosing the right balance between debt and equity is essential for the success of a business. To do so, several factors should be taken into consideration. Some of the key factors that must be considered for choosing the right mix of debt and equity financing are as follows;

  • Stage of Your Startup: Early-stage startups often lean towards equity financing as they may not have steady revenue streams to manage debt repayments.
  • Growth Potential: High-growth startups may prefer equity financing to access larger funds and expertise.
  • Cash Flow Stability: Deb financing may be more viable if your business generates predictable cash flow.
  • Risk Appetite: If you want to maintain control, consider a higher debt-to-equity ratio.
  • Market Conditions: Analyze interest rates, investor sentiment, and funding trends in your industry.

Indian Market Perspective

The Indian startup ecosystem has witnessed exponential growth in recent years. Most of its credit goes to the Government of India’s efforts to promote the business ecosystem in India. With initiatives like Startup India and Digital India, the government is aiming at easing the startups’ struggle to access funding.

  • Debt Financing Trends: Some Government-backed schemes like MUDRA loans and venture debt firms like Trifecta Capital have made debt financing more accessible for startups.
  • Equity Financing Trends: Angel investors, venture capital firms, and platforms like Shark Tank India have amplified equity financing opportunities.

Regulatory frameworks such as the Insolvency and Bankruptcy Code (IBC) also provide better security for lenders, boosting debt financing’s appeal.

Different Ways to Raise Money with Debt and Equity

Ways to Raise Money with Equity FinancingWays to Raise Money with Debt Financing
Angel InvestorsBank Loans
Venture Capital Venture Debt
Crowdfunding Convertible Debt
Initial Public Offering (IPO)Government Schemes

Conclusion

Choosing a balanced mix of debt and equity financing is important for the success of a startup. Since each option has its own pros and cons, the ideal choice depends upon your business stage, cash flow, and growth potential. In the Indian market, where opportunities and challenges go hand in hand, understanding your funding needs and leveraging the right resources can take your startup to the new heights of success.Plan wisely and choose the mix that aligns with your vision and strategy. The right decision today could define your startup’s trajectory tomorrow!