When you start a small business, you have two primary funding options. The first is taking out a loan, which is known as debt financing. The second is looking for an investor, who is typically paid with equity. Each of the options has clear advantages and disadvantages, and the best choice depends on your personal circumstances, as well as your goals for the future and the current marketplace.
Most entrepreneurs dream of finding an investor who will cut a check for them to fund their entire operation, or at least part of it. Equity financing helps individuals expand their business without taking on any debt, which means getting money without the worry of having to repay it with interest. The potential downside of equity financing, however, is the strings that come attached, and the fact that you’ll have to share profits. Before getting to the disadvantages, however, let’s look at the advantages.
The Advantages of Equity Financing
The main advantage of equity financing is the fact that it carries much less risk than a loan. You do not have to pay the money back, which means that it is the only option for people who would not qualify to take on debt or who do not feel comfortable doing so for other reasons. In addition, investor networks tend to add a great deal of credibility to a business. Thus, securing equity financing often turns into a sort of selling point, depending on the investors you attract. The vast majority of investors understand the challenges that young companies face. As a result, they can provide excellent advice while also understanding that their investment is a long-term one. Typically, investors do not expect any sort of immediate return on an investment.
Equity financing can help you maximize revenue in some ways, because a certain percentage will go to investors rather than a loan payment. During a bad month, a loan payment can break a young company, while equity financing simply means that the investor gets only a very small payout at the time. Thus, you may have more cash on hand to expand the business once it becomes profitable.
Another major benefit worth mentioning is that entrepreneurs have no liability to the investor should the company fail.
The Disadvantages of Equity Financing
Over time, as profits increase, the payments to investors will likely rise above the flat rate of a loan repayment. The investor will also demand a degree of ownership in the company in addition to a percentage of the profits. In short, this means that entrepreneurs may have to give up some control and compromise more than they would like. Typically, owners will need to consult with investors before making any major decisions, and sometimes even before making routine ones, depending on the contract. When disagreements occur, the company could be placed in jeopardy. When differences become completely irreconcilable, owners may be forced to turn the business over to the investors and be bought out completely.
Finding the right investor is the best way to avoid such disagreements, but the search for investors represents a major investment of time and other resources.
The Advantages of Debt Financing
When an entrepreneur decides to get a loan from a bank, the relationship with the lending institution is very different from that with the investor. With a bank, entrepreneurs will never need to give up part of their company or even compromise their vision. Banks and other lending institutions have absolutely no say in how you run your company, nor do they have any ownership stake in it. Once the money is paid back in full, plus interest, the business relationship ends and all profits belong to the owner.
Loans tend to be more flexible than equity financing, because you can set the term length and keep a set interest rate. At any given time, the owner knows the principal and interest, so budgeting becomes that much easier. However, a variable-rate loan can put a little more doubt in the equation. In addition, business owners should know that interest on loans is tax-deductible.
The Disadvantages of Debt Financing
Despite the advantages laid out above, debt financing also has some serious drawbacks. The most important drawback is that loans must be repaid regardless of your income or revenue, so the chances of bankruptcy increase. During hard times, debt-financed companies become particularly vulnerable, since dips in sales detract directly from the bottom line. The cash flow risk becomes more serious as companies start to rely more on debt. Too much debt can also hinder the potential for equity financing in the future. Investors see companies that carry a large amount of debt as high-risk investments.
When companies take out too many loans, they may struggle to continue growing as they direct more and more funds toward repaying those debts. Other risks also exist. Assets belonging to the company may be held as collateral, and the owner might need to personally guarantee loan repayment, which puts personal credit and assets on the line.