As a small business owner seeking outside financing to grow your business, there are two primary approaches to raising that capital: equity or debt financing. To determine which option would be best for your business, let’s break down what these two options are, as well as the advantages and disadvantages to each.
Equity financing involves selling a percentage of your business to an investor, in exchange for capital. Debt financing, on the other hand, is a sum of money borrowed from a lender that you pay back over time (with interest).
First, a deeper dive into debt financing:You may already be familiar with a few common types of debt financing – mortgages and student loans, for example. There are a number of ways to go about using debt to finance your business:
Credit cards
Credit cards extend a line of credit that you are expected to repay with interest after a set grace period has elapsed. Though they are easily accessible, credit cards tend to have interest rates that are relatively high compared to other types of debt financing.
Term loan
A term loan is a lump sum you borrow from a lender and receive upfront, then repay in fixed amounts over a set period of time. Term loans are typically paid back on a biweekly or monthly basis, over a period of 1-5 years. You may already be familiar with some common types of term loans, like mortgages or car loans.
A line of credit
Harder to acquire due to their low interest rates and the flexibility they allow, a line of credit is an amount of capital you have access to and can draw down from as needed – great for shorter term working capital needs.
Invoice financing
Invoice financing is a loan given to a business upon proof of incoming capital to that business (i.e., an open invoice). This is commonly used as a solution for cash flow issues.
Merchant cash advance
Tailored for businesses that use a lot of credit cards, a merchant cash advance repays a loan by taking a fixed percentage of your daily credit card sales.
In order to qualify for most forms of debt financing, you’ll need to have a record of your business’s operations and profitability. You and your lender both need to be confident in your ability to repay the loan – and to secure that loan most lenders require collateral and or a personal guarantee of repayment. Some advantages of debt financing:
- You retain full ownership over your company, including decision-making authority
- There are a wide range of loan options available that can be tailored to match your use caseInterest on debt is tax-deductible
- You can usually get approval and capital quickly, particularly in comparison to equity financing
Some reasons why debt financing might not be as appealing:
- If you cannot provide adequate operating history and records of good credit and profitability, debt financing may be impossible to secure
- Debt is riskier than equity, in that it requires a guarantee of repayment
- As debt is an expense, it may limit your options for additional investment while you’re still paying off the loan
Next, a closer look at equity financing. Equity financing most often comes from a few different types of investors:
- Family and friends – Generally speaking, family and friends more often invest smaller pools of money in exchange for a small portion of the business
- Angel investors – Usually private individuals or associations interested in larger stakes of your company in exchange for a substantial investment
- Venture capital – Typically large, public investments
Equity may be your better or only option if you cannot show a record of operating history or profitability. On the other hand, angel investors and venture capitalists do tend to require the potential of a large upside to an investment in your business that could ultimately lead to a high yield in return to their investment over a period of time. This generally translates to business plans that indicate high margins for growth.
Benefits to equity financing include:
- Unlike debt financing, none of your revenue will be diverted toward repaying a loan over the course of your operations
- Investors take on the risk – they are repaid only if your business succeeds
- Investors subsequently have a stake in the success of the business, and may therefore offer advice and guidance
The final point about investor input may prove to be a downside to some business owners:
- Investors may require a say in the operations of the business – for those owners who do not want to yield control, this can be a downside
- By definition, equity financing requires you give up an ownership stake in your business
- Securing investors can be time consuming, so equity financing may not be the right option if you need capital quickly
- Most small businesses won’t ever qualify for venture capital or angel investments
In summary, the key is to match your choice of financing to your specific business need. By assessing the benefits and downsides to equity and debt financing, you should be one step closer to determining the right choice for your business.
Samantha Novick
Samantha Novick is the Social Media Manager at Bond Street, a company focused on transforming small business lending through technology, data and design.