Equity vs. Debt Financing - Know the difference
Here at IBC we get a lot of questions about different types of financing and there are many ways to get financed. Here are two of the financing sources and the pros and cons with each.
Equity financing is the process of raising capital through the sale of shares in an enterprise. Equity financing essentially refers to the sale of an ownership interest to raise funds for business purposes. For most new businesses this comes in the form of "partnership" with friends and family in exchange for the money needed to start the business.
A simple way to look at it is this. If your friend "lends" you money with the expectation that you will pay it back, with our without interest, that is debt financing, if your friend gives you money to start the business with the understanding that he now owns a percentage of your business, that is equity financing. There are investors such as angle investors and venture capital funds that will make equity based investments as well. Check out some of the pros and cons.
Pros of Equity Financing
You can use the money raised from investors for all the start-up costs instead of making large loan payments to banks or other organizations or individuals. You can get underway without the burden of debt payments. This can be a real benefit when you need a longer runway to start generating revenue.
Depending on who your investors are, they may offer valuable business assistance that you may not have. This can be important, especially in the early days of a new business. A new business often begins with a great idea but the person with the great idea might not have the business experience necessary to run a business. Taking on a equity partner that can also fill your skill gaps should be a consideration.
Cons of Equity Financing
Remember that your investors will actually own a piece of your business; how large that piece is depends on how much money they invest. You probably will not want to give up control of your business, so you have to be aware of that when you agree to take on investors. Investors do expect a share of the profits so when the business starts making money they will want to get paid.
Since your investors own a piece of your business, you are expected to act in their best interests as well as your own, or you could open yourself up to a lawsuit. In some cases, if you make your firm's securities available to just a few investors, you may not have to get into a lot of paperwork, but if you open yourself up to wide public trading, the paperwork may overwhelm you. You will need to check with the Securities and Exchange Commission to see the requirements before you make decisions on how widely you want to open up your business for investment.
This is where most of our clients end up getting the funds they need to start and expand their businesses. If you decide that you do not want to take on investors and want total control of the business yourself, you may want to pursue debt financing in order to start up your business.
The myriad of options in the debt based financing space is vast and can be confusing. Most new business owners start by tapping into the sources that they are familiar with first by using personal loans, home equity loans, and even credit cards, 401k loans etc. Sometimes they reach out to family or friends when other conventional loan options don't exist.
Pros of Debt Financing
Debt financing allows you to have control of your own destiny regarding your business. You do not have investors or partners to answer to and you can make all the decisions. You own all the profit you make.
If you finance your business using debt, the interest you repay on your loan is tax-deductible. This means that it shields part of your business income from taxes and lowers your tax liability every year. Your interest is usually based on the prime interest rate.
The lender(s) from whom you borrow money do not share in your profits. All you have to do is make your loan payments in a timely manner.
There are a lot of options and the US government has some great programs to help support new businesses.
Cons of Debt Financing
The disadvantages of borrowing money for a small business can be significant if you are not careful. Business owners often want something so bad they take a loan that is not right for their business. For example, you may have large loan payment due at precisely the time you need funds for start-up costs. If you don't make loan payments on time to credit cards or commercial banks, you can ruin your credit rating and make borrowing in the future difficult or impossible. If you don't make your loan payments on time to family and friends, you can strain those relationships. Being realistic about the debt you take on is critical.
For a new business, commercial banks may require you to pledge your personal assets before they will give you a loan. If your business goes under, you will lose your personal assets. Understand the terms of your loan and be sure of the repayment strategy. There are literally thousands of options for debt financing with different terms. Know your repayment thresholds and don't settle for something that puts your personal assets at risk.
Any time you use debt financing, you are running the risk of bankruptcy. The more debt financing you use, the higher the risk of bankruptcy. Calculate the debt to equity ratio to determine how much debt your business is in compared to its equity is critical.
So the question is, which options are right for you?
It depends on the situation. Your financial capital, potential investors, credit standing, business plan, tax situation, the tax situation of your investors, and the type of business you plan to start all have an impact on that decision. The mix of debt and equity financing that you use will determine your cost of capital for your business. The good news is, there are a lot of options and that bad news is there are a lot of options. Getting the right funding is absolutely critical to the long-term success of your business so make sure you get it right. Do you homework, find the right investors and right lenders, and if you have not been through the process before, find someone that has been through it to help you navigate the options.