When the business's existing cash flow can service the loan without the growth paying off, debt is usually far cheaper than equity. A loan costs interest and is repaid; selling a stake at today's valuation hands an investor a permanent share of the whole company's future earnings and sale value. Equity becomes the better choice when the company already carries as much debt as lenders allow, when the growth is uncertain enough that debt service could break the business, when there are no historical earnings to lend against, or when the investor brings something besides money.
- What debt costs
- Interest for the life of the loan, then nothing
- What equity costs
- A share of all future earnings and sale value, permanently
- Debt works when
- Today's cash flow covers the payments even if the growth is slow
- Equity works when
- Leverage is already full, results are volatile or unproven, or the partner adds value
- Middle ground
- SBA 7(a), equipment financing, mezzanine, preferred equity, a delayed-draw loan
Why the comparison is lopsided
Owners often compare the two by asking which one is harder to get or which one comes with more strings. The more useful question is what each one costs over the years that matter. A lender's return is capped: principal back, plus interest. An equity investor's return is not: it takes its percentage of every future year's profit and of the price when the company is eventually sold. If the growth works, the investor's share grows with it, and the owner has sold part of the upside at a price set before anyone knew it would work.
There is a second, less visible cost. An investor buying in at today's valuation is buying a share of the whole company, not just the new project. The owner who funds a new location by selling a stake gives up part of the existing business too, the part that did not need the investor's money at all.
A loan is paid off. A stake is paid out every year, and again at the sale.
A worked example
Figures in thousands. A company with EBITDA of 3,000 and no debt wants to open a second facility. The project needs 4,000 for equipment, build-out and working capital and is expected to add 1,000 of EBITDA once it ramps up in year three. It has two ways to pay for it.
- Debt: a term loan of 4,000, repaid in equal principal installments over five years, with interest of 400 in the first year falling as the balance comes down: 1,200 of interest in total. At closing, 4,000 of debt on 3,000 of EBITDA sits below the 2x to 3.5x EBITDA that senior cash-flow lenders commonly lend, and first-year debt service of 1,200 against EBITDA of 3,000 is comfortably above the 1.25x coverage conventional banks commonly look for.
- Equity: an investor values the company at 18,000 before the new money and invests 4,000, so it owns 4,000 of a 22,000 total value: a little over 18 of every 100 shares.
Assume the plan works: EBITDA of 3,000 in year one, 3,400 in year two and 4,000 in years three to five, a total of 18,400, and the company worth 24,000 at the end of year five, the same value relative to earnings as today.
| Over five years | Debt route | Equity route |
|---|---|---|
| Paid to the capital provider | 4,000 of principal plus 1,200 of interest: 5,200 | Nothing required, but the investor owns its share of everything |
| Provider's share of five years of earnings | None | About 3,345 of the 18,400 |
| Provider's share of the company at year five | None; the loan is repaid | About 4,364 of the 24,000 |
| Total that goes to the provider | 5,200 | About 7,709 |
| Owner's ownership after year five | All of it | A little under 82 of every 100 shares |
| Cost from year six onward | Nothing | About 727 of every year's 4,000 of EBITDA, plus its share of the sale |
On plan, equity costs about 2,500 more over five years, and the gap widens every year after, because the loan is gone and the investor is not. That is the ordinary shape of the comparison when the business can carry the debt. How much debt a business can carry covers how lenders decide where that line is.
Where debt stops being the cheaper answer
The example worked for debt because the existing business could pay the loan whether or not the project worked. Change that, and the answer changes. The table runs the same two routes through outcomes that are less kind.
| What happens | Debt route | Equity route |
|---|---|---|
| The plan works | Cheaper by about 2,500 over five years, and more after | The investor shares the upside it did not build |
| The project adds nothing, the core business holds | Owner bears the whole 5,200 but the core business still covers the payments | Investor shares the loss; owner is diluted for a project that failed |
| The project adds nothing and core EBITDA falls to 1,400 | First-year debt service of 1,200 leaves coverage below the 1.25x banks commonly look for: a likely covenant breach and a hard lender conversation | No payment falls due; the business has time to recover |
| The company already has 7,000 of debt | 11,000 of debt on 3,000 of EBITDA is past what senior cash-flow lenders commonly lend; only more expensive layers remain | Unaffected by existing leverage, though the investor will price it in |
The pattern is consistent. Debt is cheaper whenever the downside is survivable, and it is survivable when today's earnings, not tomorrow's, cover the payments with room to spare. Equity earns its cost in four situations:
- Leverage is already full. Past what senior lenders will do, the next layer is mezzanine or preferred equity, and the cost gap to common equity narrows.
- Results are volatile. A business whose earnings can fall sharply in a bad year should not add fixed payments that assume a good one.
- The growth has no track record. Lenders lend on historical earnings, and only partly on projections; see lending on run-rate and projected EBITDA. A new product line with no revenue is an equity bet.
- The investor brings something. Customers, a management team, an acquisition pipeline or a path to a larger sale can be worth more than the dilution.
The options between plain debt and common equity
Growth capital is rarely a choice between two pure forms. Most expansions can be funded with a mix, and the mix is where most of the savings are.
| Option | What it is | Fits when |
|---|---|---|
| SBA 7(a) | A guaranteed loan up to $5 million, with long maturities that keep payments low | Expansion by an owner-operated company that fits SBA's rules; owners of 20% or more guarantee it |
| Equipment financing | A loan or lease secured by the equipment itself | A large share of the project is machinery or vehicles; see equipment loans beside senior debt |
| Delayed-draw term loan | A committed loan drawn as the project spends | Staged spending, so interest is not paid on idle cash; see delayed-draw term loans |
| Asset-based line | Borrowing against receivables and inventory | Growth mostly needs working capital |
| Mezzanine debt | Subordinated debt with higher interest and often warrants | More debt is needed than senior lenders will provide |
| Preferred equity | Equity with a fixed preferred return and priority over common | The owner wants to limit dilution and avoid fixed payments |
| Minority common equity | An investor buys a share of the company | The downside needs sharing or the partner adds value; see minority equity vs debt for growth |
Layering usually beats either extreme: senior debt up to a comfortable coverage level, equipment financing for the equipment, and equity, if any, only for the part that debt cannot safely carry. What a layered capital stack costs shows how to price the combination, and warrants and equity kickers covers the dilution that some debt carries with it.
How to decide for your company
Start with the downside, not the plan. Build the forecast with the growth delayed a year and the core business in a bad year, and check whether debt service is still covered. If it is, borrow, and keep the equity. If it is not, size the debt to the level that survives the downside and fund the rest with equity or a structure that has no fixed payments.
- Use historical earnings for sizing. Lenders will.
- Separate the spending: equipment, real estate and working capital each have a natural lender, and each is cheaper than a general loan or equity.
- Price equity as a share of the whole company over the years you expect to own it, not as the check you receive.
- Read the investor's terms beyond price: preferences, board seats, consent rights and exit rights all cost something.
- Keep room under any covenant; see covenant headroom.
Transparent's lender book holds 1,800+ lenders, and 1,148 of them write term and private credit. The financing model in the package Transparent builds runs the base case and the downside side by side, so an owner can see how much of an expansion the business can carry as debt before deciding how much of the company to sell.
Common questions
- Is debt always cheaper than equity?
- When the business can service it from existing cash flow, almost always. When the debt could only be repaid if the growth works, equity's higher cost buys protection that debt cannot give.
- Why does selling equity at today's valuation cost so much?
- Because the investor buys a share of the whole company, including the part that existed before its money arrived, and shares in the value the new money creates, permanently.
- Can I use an SBA loan for expansion?
- Yes. SBA 7(a) loans go up to $5 million and can fund equipment, real estate and working capital for expansion, subject to SBA's rules. Every owner of 20% or more personally guarantees the loan.
- Will lenders lend against the earnings the expansion will produce?
- Mostly not. Lenders size loans on historical earnings, with limited credit for projections. The existing business needs to carry the payments.
- What about a mix of debt and equity?
- Often the best answer: borrow up to a level the downside case supports, finance equipment against itself, and use equity only for what is left.