Debt Financing vs. Equity Financing
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Most small business owners will need deeper pockets than their own to start or expand their companies, but financial assistance doesn’t come free. The question: Borrow money, possibly at high interest rates, or exchange company ownership for cash instead?
Debt financing and equity financing both provide money for your business, but one requires you to pay back what you borrow while the other allows you to offer a share — perhaps a significant slice — of your company. We’ll take a look at both types of financing to help you decide which is best for your small business.
Debt vs. equity financing: What’s the difference?
When you need an infusion of capital, you have a number of ways to obtain money for your business. The type of financing you choose would depend on what you’re willing to provide in exchange for capital, said Jeffrey Robinson, assistant professor of management and entrepreneurship at Rutgers University.
Debt financing occurs when you borrow money from an individual or a financial institution and you must pay it back in installments over time, usually with interest, Robinson said. Debt financing could include borrowing from yourself, money from your personal savings or retirement accounts that you would want to eventually replenish.
Most small business owners turn to debt financing when first starting out because it allows them to borrow money and maintain full control of their company, Robinson said.
“The good thing is you still have full ownership,” he said. “The bad thing is you are now taking on debt.”
If you seek debt financing in the form of a small business loan from a traditional bank, you may have to offer assets as collateral to secure a loan or business line of credit. If you can’t pay back your debt, the bank will seize your assets. For many new small business owners, the most valuable asset they can offer is their house, Robinson said.
Traditional debt financing
Debt financing can come in several forms, depending on the repayment plan that works best for your business, said Vijay Singh, finance professor at Lehigh University. You could choose a:
- Fixed rate loan, which would have the same interest rate for the full loan term
- Floating or variable rate loan, which would come with a fluctuating interest rate
We’ll describe some other options for debt financing below.
Equity financing allows you to obtain funds from an individual or firm, but you give them a percentage of ownership of your company rather than paying back the funds, Robinson said. The investor’s return would depend on the success of the business, and they would feel the impact of profit and losses along with you.
“You have somebody now who has ownership stake in your business,” Robinson said. “They also have a say in how you run it.”
If you keep investors’ ownership below 20%, you should still be able to operate the company how you want, Robinson said. If you grant investors more than a 50% stake in your business, then your control would be at risk.
Investors or partners would be involved in the business until you buy them out, which could end up being complicated down the line, Robinson said. But equity financing often comes with another benefit: advice or mentorship from the person(s) making the investment. Perhaps even more than money, it’s this support that makes equity financing an attractive option, he said.
Bringing on a partner through equity financing during the early days of the business could increase your chances of being approved for debt financing later, Singh said. You would have the capital to get the business off the ground and gain the experience that lenders typically look for when issuing loans or lines of credit.
Before you make an agreement with an investor, you should do your own due diligence and research their investing history, Robinson said.
- Ask for references: You could talk to another business a potential partner has invested in to find out how involved they are in day-to-day operations to give you an idea of what to expect. “Once you sign the paper, you and that person are connected,” Robinson said. “Just because the money is being offered doesn’t mean it’s the right person to get it from.”
- Consult a lawyer: Hiring a lawyer to assist with the financing agreement could help you avoid problems in the future, Singh said. The agreement should spell out the responsibilities and rights of everyone who has ownership of the company. It may also be a good idea to run a background check on investors to make sure you trust the people you’re doing business with, Singh said. “You can screw things up by selling a stake to somebody who’s not a good guy to work with,” he said. “At the end of the day, you have to have a lot of trust. If you lack trust, you have a huge problem.”
Types of debt financing
Friends and family
Close friends and family members who are in a position to help entrepreneurs succeed are often the first source of financing for new business owners. Although you would still have to pay back the money you borrow, your friends and family may not charge you as much interest as other lenders would. Family and friends could also provide equity financing if they want to buy a stake in the business.
Although banks are hesitant to lend money to new businesses, your regular bank may approve you for a business loan if you’ve already established a good relationship. Banks can be a less risky option than borrowing from some alternative lenders. But you may have to meet strict financial requirements to qualify for financing. Small banks held nearly 53% of small loans to businesses in 2017, according to the Federal Deposit Insurance Corporation (FDIC).
Many alternative small business lenders operate online and help entrepreneurs obtain funding quickly. Companies like OnDeck, Funding Circle and National Funding offer online applications and nearly immediate financing. Eligibility requirements are typically forgiving and business owners with little experience or poor credit may be approved. Not all online lenders are reputable, so you would need to research the company before accepting a business loan or credit.
Types of equity financing
Angel investors have personal wealth or disposable income that they invest in young companies. Startups often obtain their first round of funding from angel investors, but several angels might be needed to generate a sizeable amount of money. Finding angel investors could be difficult, as it would depend on your connection to your local business and investing community.
Venture capitalists work independently or for private equity firms that make major investments in growing companies. Micro VCs typically invest between $500,000 and $2 million, while traditional VCs invest $5 million or more. VCs tend to prefer established businesses with a high-growth trajectory. Competition is steep and just 2% of businesses that request VC funding actually receive money.
Which one is right for your business?
Choosing equity financing or debt financing boils down to whether or not you’re willing to give up total control of your business. You may even consider a combination of both options.
“Think about what that amount of money is worth in terms of ownership in the company and whether you’re willing to give up that ownership for what is hopefully money plus something else that makes a difference in your business,” Robinson said.
There are a few other factors you can consider when making your decision:
The stage of your business. Debt financing may be best for a new business, especially if you can get approved for a loan with a low interest rate and manageable terms, Robinson said. You would be able to maintain control of the business during the early days.
However, lenders are not always willing to approve new business owners for loans and credit, Robinson said. Financial institutions will often take your personal financial history into consideration if your business is not yet established. Investors typically don’t have the same strict requirements for business owners, which could make equity financing a better option if your credit isn’t good enough to get a bank loan, he said.
“They don’t have to go to an underwriter,” Robinson said. “They have a lot more flexibility in terms of who they will fund.”
The amount you’re seeking. Business owners can typically secure a larger amount of funding through equity financing than debt financing, Robinson said. An angel investor might be willing to put $200,000 to $500,000 into your business, while a bank might not loan you more than $150,000, he said.
If you need a smaller amount, microloans from small community banks or Community Development Financial Institutions could be a good option, Robinson said. CDFIs typically issue business loans between $35,000 and $50,000 and they often have more lenient requirements.
“They work with a lot of small businesses,” he said. “They’re willing to work with you.”
Your revenue. Debt financing would be a good option if you know your business can quickly bring in revenue, Robinson said. You would need substantial cash flow to cover daily or monthly loan payments, which could start shortly after you receive funding.
“If you know you’re going to be making money right away that’s a good thing because you have something to pay back,” he said.
On the other hand, equity financing could be a better option if your new business needs a few years to begin turning a profit, he said. Investors may not rush a return on their investment if you can prove the future value of the business.
“If you know the payoff isn’t for years to come, you might want to bring in some investors,” he said. “They might be willing to wait a little longer.”
Your desired ownership. Entrepreneurs are often hesitant to work with partners and give up a piece of their business. But the infusion of cash and the value of partnering with an investor can be worth giving up some control, Robinson said. With the connections and mentorship that partners provide, your business could grow more than it would with you at the helm on your own.
“Sometimes business owners get hung up on being the captain of the tugboat when they could be a co-captain of a cruise ship,” Robinson said.