Whether you’re planning an expansion or simply covering day-to-day costs during a time of recession, at some point, pretty much all businesses will need to raise extra capital. From small business investors like ValueStreet to crowdfunding to traditional bank loans and business checking accounts, there are many different financing options to choose from or you could get assistance from business bookkeeping services.
In this article, we’ll talk about the two main types of funding options available: debt financing and equity financing. We’ll look at how both of these financing options work, cover the pros and cons of each, and discuss how you can make an informed decision for your small business, just make sure that you have a professional accountant to keep track of all of your finances.
The Basics of Debt Financing and Equity Financing
There are two primary types of financing available to small businesses: debt financing and equity financing. While they will both provide an influx of capital to your business, they are also very different from each other.
What is debt financing and how does it work?
Debt financing is when a business borrows a fixed amount of money from a lender with an agreement to pay back the principal sum, with interest, in a specified amount of time. Small business bank loans, credit cards, and credit lines are the most common types of debt financing. However, money can come from a variety of sources. In addition to banks and credit unions, debt financing can also come from non-profit groups and even friends and family. Sometimes a lender will require collateral to secure the business loan. This could include anything of value including business assets such as accounts receivables, buildings, vehicles, or inventory. If the loan were to default and the borrower could not pay off the debt, the lender would then have the option of selling these assets to pay off the loan.
What is equity financing and how does it work?
Equity financing is funding that comes from small business investors that buy equity investment into your company, typically in return for a percentage of profits. Small business investors can be private equity firms or, just as with debt financing, they can also be friends and family. Sometimes, but not always, a small business investor may be granted some amount of control in the business. This will depend on the terms of the deal. Most small business investors will structure a profit-sharing arrangement that anticipates seeing a predictable return on their investment.
The Pros and Cons of Debt and Equity Financing
Advantages of Debt Financing
With debt financing, once you have repaid your debt, you have no obligations and you are done with the relationship. Because you are not selling a stake in your company, there is never any change to the business ownership. Other advantages of debt financing include having a variety of lending options to choose from and the fact that any interest you pay on the loan is tax deductible.
Disadvantages of Debt Financing
Debt financing may require collateral to secure a loan and terms will require that you pay back a specified amount of money no matter how well your company is doing. If you borrow money from a lender and your business doesn’t perform well, they probably only care about their bottom line. This can lead to serious cash flow issues, defaulting on loan payments, and risking the loss of any assets you provided as collateral for the loan. Additionally, while lenders may not have any say in how your business is run, they do have the option of imposing restrictions that can dictate how the money you borrow is used.
Advantages of Equity Financing
One of the main advantages of equity financing through small business investors is that they will not charge you interest on their investment into your company. This means you’ll have more money available to invest back into the success of your business. Another big advantage is that equity investors often provide a great degree of experience and business leadership. With equity financing, small business investors only see a return on their investment if your business is a success. Small business investors also have a much greater incentive to ensure that your business succeeds and can often provide expert guidance to help your business thrive. At the first sign of trouble, their first inclination will be to help you in any way they can. After all, they have a stake in the success of your business. In contrast, if a bank sees that you’re in trouble, their main concern will be making sure they still get their monthly loan payments.
Disadvantages of Equity Financing
Handing over even a little bit of decision-making power is not for every business owner. No matter what type of expertise a small business investor has to offer, some owners do not want to involve a third-party in the operations and management of their business. Additionally, while equity financing does not require the repayment of a principal sum with interest, you will typically create an agreement to share a certain percentage of your profits with small business investors that you have partnered with.
If your business needs an injection of extra capital, your best course of action is to do your homework about loans available and pertinent small business investors. You’ll be better equipped to make a decision by committing these basics of debt and equity financing to knowledge, and by carefully weighing out the various pros and cons with your business needs and goals. Whichever one you choose, be sure it offers the right balance between risk and reward. In the end, the most important part of any business decision about raising capital is having a solid plan on how you will effectively leverage it.