Debt vs Equity Financing: Which is Better for Financing Your Small Business?
It’s a popular cliché that is thrown around, “It takes money to make money.” While this is largely untrue for individual employees, it is true for entrepreneurs looking to start and grow a business.
After all, real estate, inventory, marketing campaigns, and labor all cost money. Even starting a virtual company costs money in the form of website development, hosting, and other basic operating expenses.
That’s money you don’t necessarily have in a savings account.
So where do you get the money to start a business? While there are many ways to finance a business, most involve taking on debt or giving up equity.
Financing your startup with debt
You understand how debt works, even if you don’t know all the loan options available to you.
Be sure to explore all of your business debt financing options before committing to any option. Beyond the many types of business loans (including SBA loans), you can also get a personal loan, tap into your home equity, or use personal or business credit cards.
You can also borrow money from friends or family if you don’t mind risking your relationship on an unproven startup.
But keep these pros and cons in mind before you sign on the dotted line with any lender, be it a bank or a sibling.
Advantages of debt financing
Borrowing money to finance your business has many advantages over the alternatives.
You keep 100% of your business
When you borrow money, you have debt, but you don’t have to give up a percentage of your business.
That makes your relationship with your financier easy. You owe them a predictable monthly payment over a specified period. Once you repay them in full, you part and owe them nothing more.
You maintain financial and administrative control
Because you keep 100% of your business, no one can tell you how to run it. And for the most part, they also can’t tell you how to spend and invest your funds.
You can hire who you want, fire who you want, expand how you want, and market your goods or services how you want. If you want to pivot to take advantage of a new opportunity in the market, there is no stopping you.
He remains firmly entrenched in the driver’s seat, with no gallery of peanuts to tell him what to do.
Fast and flexible financing options
Theoretically, you could borrow money for your small business in the next five minutes by opening a business credit card or getting automatically approved for a loan.
And as described above, you have many different options to choose from for borrowing money. You can borrow $200 from a friend or $2 million through an SBA loan, with many other options in between.
You can deduct interest
No one likes to pay interest on loans, but deducting the cost of interest on your tax return takes some of the pain out of it.
It also reduces the effective cost of borrowing money for your business. If you pay $1,000 in interest over the next year but are taxed at the 24% tax rate and can deduct that $1,000 from your taxable income, then you effectively pay $760 in interest.
Debt Financing Cons
Of course, debt isn’t exactly something to celebrate. It comes with a lot of drawbacks for businessmen looking to hang their shingles.
Cost
You have to pay interest on your debt, and “tax deductible” does not mean “free.”
Potentially high-interest rates aside, regular monthly loan payments also affect your cash flow. It takes longer to make a profit when added to your monthly expenses.
When you borrow money, spend it wisely so that it grows your business.
Too many fledgling entrepreneurs spend their start-up capital on expenses that simply don’t do much to improve their bottom line, like hiring expensive graphic designers to put a distinctive touch on their logo or lavish office space when they could have kept the company in a remote location.
And when the time comes to pay the piper, they take out their empty pockets.
You must qualify for a loan
There isn’t just one magic money ATM you can walk up to and get cash out. Someone has to agree to lend you their money, which they only do if they feel confident that, you know, you’ll pay them back.
Sometimes qualifying for a loan is as simple as asking your dad, but usually, it involves a bank reviewing your credit history, business plan, tax returns, and assets. A bad credit rating alone can sink your loan hopes, just like other factors.
Get serious about improving your credit and cleaning up your financial statements long before you want to borrow money, to increase your chances of success.
Consequences of non-compliance
When you default on a loan, the lender typically doesn’t shrug and say, “Oh, well, you did your best!”
Sometimes they secure the loan with specific business assets of yours, such as your inventory or equipment. Most business loans also require personal collateral, so lenders can go after your assets, like your home or car if you don’t.
Borrower beware.
Financing your company with equity
New entrepreneurs are often less familiar with how equity financing works than they are with debt financing.
With equity financing, the small business owner typically gives up a percentage of their property in exchange for an injection of capital. The most common examples of equity investors are venture capitalists (think “Shark Tank”) and angel investors, which are similar but not identical.
While venture capital firms tend to be just that, corporate firms and angel investors are often wealthy individuals looking to invest in promising young companies.
Today you can raise money through crowdfunding platforms for entrepreneurs. Your friends or family may offer to finance your startup in exchange for an equity stake, either through one of these platforms or less formally.
Consider these pros and cons before you give away any part of your business.
Advantages of Equity Financing
Despite the daunting thought of giving up part of your business, equity financing has its unique advantages.
No onerous debt payments
As described above, monthly debt payments hurt your cash flow and make it harder to turn a profit.
When you raise money by offering an equity stake, you don’t have to make regular payments. Typically, your partners plan to be paid in the future, when you sell your business to a larger competitor or go public through an initial public offering.
Partners bring experience and connections
His equity partners now have a vested interest in seeing him succeed. Which means they will do everything they can to help you achieve it.
Oftentimes, venture capitalists and angel investors bring a wealth of experience in the same industry. They can help you avoid roadblocks and mistakes that ruin other businesses in your space. Instead of reinventing the wheel yourself, you gain the collective wisdom and experience of their other successes.
They also often bring a network of people who can help you succeed. These can be vendors, suppliers, technical teams, contractors, or support services like accounting. They can even connect you with great potential customers.
The size and quality of your business network often determine its success or failure. strong stop.
Fewer resources if your company fails
Venture capitalists and angel investors don’t usually take your home if your business fails. They also don’t ruin your credit by reporting to credit reporting agencies.
That doesn’t mean they’ll take you out for dinner or vouch for you in the industry again. But the consequences of failure are usually less severe than if you default on a bank loan.
Cons of Equity Financing
Giving up an equity stake in your company also has many disadvantages. Make sure you fully understand them before committing.
Loss of future benefits
If your business takes off and is successful, you won’t reap all the rewards. You have to share with your partners.
Unlike the simple borrower-lender relationship, equity partners forge a complex and ongoing relationship. They are stuck until the company is sold, goes public, or files for bankruptcy, or until one party buys out the other.
You could discover that you can’t stand your partner. Or that they don’t bring the wisdom and connections they initially promised.
Or that their “meddling” and the company’s vision directly contradict yours.
Loss of administrative and financial control
When you give up part of your ownership interest, you give up control of your business. That means you need to discuss all major business decisions with your partner.
They may see the future of the company quite differently than you do, want to expand into a different market than you do, or want to stay in their current market when they see more opportunities elsewhere.
Also, they may want to invest resources differently than you do. They want to put most of their shared capital into a marketing strategy, while you want to invest money in another way.
You are married now, for richer or poorer, for better or for worse.
Slow initial fundraising
It could take months for a venture capital firm to give you the green light for equity financing.
You have to prepare a presentation, your business plan, and detailed projections and financials, and go through a whole dog and pony show just to make your case for why they should consider investing and partnering with you.
By contrast, commercial loans often move much faster, though not necessarily, particularly with all the red tape involved with an SBA loan.
Should I finance my business with debt or equity?
As you explore all of your options, ask yourself a few key questions. The answers will help you determine exactly how to raise money for your business.
These questions revolve around the following criteria:
Speed and urgency
How quickly do you want (or need) the money?
If you need it quickly, you probably don’t have time to attract stock investors. They go through their procedures at their own pace and are turned off by the smell of despair.
Explore loans to move faster.
Fundraising Amount
How much money do you want or need?
The less money you need, the more likely you are to be able to borrow it and avoid giving up ownership of your business. An entrepreneur who only needs $10,000 can probably get it with a credit card if all else fails, while someone who needs $5 million has fewer options.
The appeal of experience and connections
Do you just want cash or do you also want experienced mentors and a wide network of connections?
If you just want money, a loan may meet your needs. But if you want to get started right away with support from experts in your industry and a wide range of connections, it’s often worth giving up a piece of your company to secure them.
Openness to share
Do you mind sharing ownership of your business or do you want to retain 100% financial, administrative, and creative control over it?
Some entrepreneurs would rather cut off a limb than relinquish control of their baby. Others prefer to bring in as much outside experience as possible in hopes of growing quickly.
And really, some people just don’t play well with others. Know yourself well enough to choose wisely.
Long term goal
What is your long-term goal for the business and your exit strategy?
For all the complexity that talking heads bring to this question, there are only two models for business success.
The first aims to collect as soon as possible. You grow your business as quickly as possible, with the goal of either selling it to a bigger fish in the pond or making an initial public offering.
The other model is a lifestyle business: a low-expense, low-stress, high-income business that you continue to work for many years because you enjoy it and it generates a strong income. It could be a sole proprietorship, where you work alone, or it could be a local or online business with a relatively small team.
These entrepreneurs do not pursue growth for growth’s sake, but only to the extent that it generates more profit, rather than simply adding more revenue with equally greater complexity and cost. Their exit strategy involves passing the business on to their children or selling it to someone they like when they retire.
Entrepreneurs who want to get paid quickly should consider raising money through both equity and debt. But entrepreneurs looking to build a lifestyle business should use debt or finance their business through savings.
A third option: your savings and income
My business partner and I finance our own business with savings. But not, as it turned out, in the way we had originally envisioned.
At first, we had some seed money set aside in a savings account. At first, we thought it was enough money to drive us to profitability.
Then our web developer walked away with half of our start-up capital. Then another partner went out of business and left us with no ready replacement. And the crises went on and on, which is what start-ups tend to do.
At one point, each of us went the extra mile to generate some income while we continued to build our business. My partner dusted off his real estate license. I started writing on my own. We both asked our (unhappy) spouses to live as poorly as possible, maximizing our savings rates so we could pump as much money as possible into our business.
And at a certain point, we made a profit.
Alternatively, you can start a business on the side while working a full-time job. Regardless of what you consider your “main job” versus your “side job,” you continue to earn money to help you and your business float financially until you make enough profit to quit.
What you may never do. My partner and I have continued to work our side jobs long after our company became profitable, for the simple reason that we enjoy it. And it helps our spouses sleep at night knowing that each of us has a floor of income.
Conclusions
Starting a business is the hardest thing I’ve ever done in my life. Harder than moving abroad and making new friends in my late 30s, harder than raising a child, and harder than my goal of achieving financial independence within five years of being broke.
It has been absolutely and positively worth it.
I have never felt more committed to my work. It has forced me to grow as a person in unexpected ways and has opened amazing doors and opportunities for me.
Despite my original experience in rental investments, for example, I invest my money today in ways I never would have discovered if I hadn’t started a business instead of continuing to sign someone else up every day.
If you believe that starting a business is not just your best option, but your only option for a fulfilling life, I wish you good luck. Now you just need to find a way to pay for it.
