The choice between debt and equity is frequently framed as a preference. It is better understood as a match between the risk profile of what you are funding and the risk tolerance of the money.
The fundamental difference
Debt must be repaid on a schedule regardless of how the business performs. It is cheaper because the lender takes less risk, it does not dilute ownership, and it is unforgiving of a bad year.
Equity does not have to be repaid. It is more expensive in the sense that investors expect a much higher return, it dilutes ownership and control permanently, and it survives a bad year without putting the business at risk.
Match the funding to the certainty of the return
The useful test is how confident you are about the cash the investment will generate.
Debt suits investments with predictable returns and, ideally, security value: property, plant and equipment with an established use, acquisition of a profitable business, and working capital growth in a proven model.
Equity suits investments where the return is uncertain: market development, product development, entering a new category, and anything where you might be wrong.
Funding an uncertain investment with debt is how businesses fail. The investment does not produce the expected cash, and the repayments arrive anyway.
What lenders assess
- Serviceability — whether cash generation covers repayments, stress-tested at higher rates.
- Security — what can be realised, at what discount.
- Track record and management capability.
- Concentration risk — dependence on one customer, contract or commodity.
Personal guarantees are standard for SME lending, and they remove the liability protection incorporation provided. Directors should be able to list their outstanding guarantees, and many cannot.
Watch the covenants. Financial covenants give the lender rights that can be exercised at the worst moment, and they should be monitored monthly rather than discovered at balance date.
What equity investors assess
Growth rate, market size, the team, and a credible path to an exit. Investors need a return through sale or listing, which shapes what they will back.
A business that will be profitable and family-owned in fifteen years is a good business and a poor fit for institutional equity. Founders who conclude their business is weak because venture investors declined it have usually just used the wrong instrument.
Terms matter more than valuation
Founders negotiate valuation hard and terms barely at all.
Liquidation preference, board composition, reserved matters requiring investor consent, anti-dilution provisions and drag-along rights determine what actually happens in most outcomes. A higher valuation with a participating preference can leave founders worse off than a lower valuation on clean terms.
Take advice from a lawyer who does these transactions regularly, before signing a term sheet.
The middle options
The choice is not binary:
- Invoice finance funds working capital growth without term debt or dilution, and scales with turnover.
- Asset finance secured against the equipment preserves other facilities.
- Vendor finance in an acquisition, where the seller carries part of the price.
- Convertible notes, which defer the valuation question.
- Retained earnings — the cheapest capital available, and the one that constrains growth rate.
Shareholder continuity and losses
Issuing shares to a new investor can breach the shareholder continuity requirement for carrying forward tax losses. The business continuity test provides some relief with conditions.
Raise this with your accountant before an equity raise. Forfeiting accumulated losses is an avoidable cost that surfaces after the deal has closed.
Before raising anything
Check whether the problem is actually a funding problem. Extended debtor days, excess stock, underpriced work and unclaimed tax credits all present as cash shortages and none are solved by borrowing or diluting.
Fixing the underlying issue is almost always cheaper than financing it.
The Financial Markets Authority publishes capital raising material, and business.govt.nz publishes funding guidance. Both free.
General information only, not financial advice.
