If you’re trying to launch a business, you’ve probably considered both debt financing and equity financing. However, decipher the differences between these two avenues and choose the right one for your business. Thankfully, we are here to guide both debt and equity financing options:
What Is Debt Financing?
Debt financing involves accepting funds as a debt that must be repaid. Debt financing requires monthly payments to be made to cover both the cost of the principal that was originally borrowed and the interest that accrues throughout the loan term. Debt financing usually involves established financial institutions that may have strict qualification requirements.
What Are the Different Types of Debt Financing?
Here are some of the most common types of debt financing that you may want to consider for your small business:
- Traditional bank loans: Some banks offer traditional loans to small businesses. However, these loans can be difficult to qualify for, especially if you’re just starting. If you do qualify, these loans can be ideal, thanks to lower interest rates.
- SBA loans: The federal government knows that it can be hard for small businesses to get loans from banks which is where the Small Business Administration (SBA) comes into play. The SBA works with banking partners to offer loans to small businesses that qualify. Since the federal government guarantees that they will repay these loans, it’s less risky for the lenders involved.
- Merchant cash advances: For small businesses that earn most of their sales through debit or credit cards, there are merchant cash advances (MCAs). With an MCA, you’re able to get cash now in exchange for a portion of your debit or credit card sales later. From there, you usually get put on a daily or weekly repayment schedule, often with high APRs, until the cash advance is paid off.
- Lines of credit: Lines of credit give small businesses access to a sum of money that they can use as they wish. With a line of credit, you only pay interest on the amount that you borrow.
- Business credit cards: Business credit cards fall under lines of credit — the difference being that lines of credit use checks or bank transfers wherein credit cards use an actual card to make payments both in-person and online.
What Are the Pros and Cons of Debt Financing?
While debt financing might seem like a great way to fund your small business, there are both pros and cons that you should know about before you sign on the dotted line.
Pros
- Perhaps the biggest pro of debt financing is that you’re able to maintain full ownership and control of your business.
- Debt financing comes with clear terms — including interest rates and repayment timeframes so that you know what you’re signing up for.
- The interest payments that you make on debt financing are tax-deductible so that you’re able to save money come tax season.
Cons
- Since you borrowed the money and agreed to a repayment schedule, you’re on the hook even if your business fails.
- If you’re unable to make your payments, you risk defaulting and potentially losing the assets that you pledged as collateral.
- Interest rates can quickly add up over time and may make it difficult for you to pay off the loan.
What Is Equity Financing?
Equity financing involves accepting funds in exchange for a share of your business. And while equity financing is not a loan that has to be repaid, equity investors can have a say over business decisions and share profits. Equity financing is available to new startups and small businesses since individuals make financing decisions rather than corporations with strict requirements.
What Are the Different Types of Equity Financing?
Here are some of the most common types of equity financing that you may want to consider for your small business:
- Angel investors: Angel investors provide funding to small and startup businesses out of their own pockets. In exchange for this funding, businesses have to give up some of their equity to the investor. These individuals usually have high salaries and net worths.
- Venture capitalists: Venture capitalists are individuals or organizations that provide funding to more established small and startup businesses. They also usually provide larger amounts of capital compared to angel investors. However, they too require some equity to make the investment and risk worthwhile for them.
- Equity crowdfunding: Crowdfunding involves selling small shares of a company to investors through crowdfunding platforms. While crowdfunding can be successful, much marketing work and luck are required to earn the funding you’re looking for.
What Are the Pros and Cons of Equity Financing?
While equity financing might seem like a great way to fund your small business, there are both pros and cons that you should consider before you agree:
Pros
- There’s usually no equity financing repayment obligation unless your business succeeds and grows as planned, so there’s little to no risk involved for the business owner.
- These options are available for small and startup businesses that may struggle to qualify for the different types of debt financing.
- Instead of making regular payments, you’re able to use the funding to reinvest into your business and promote further growth.
Cons
- You usually have to give up a portion of your business to receive equity financing.
- As a result, you may lose control and say over key business decisions since you have to listen to your investors.
- Finding equity financing possibilities can be difficult and time-consuming — time that may be better spent elsewhere.
Which Option Is Best for You?
Everyone has different expectations and standards when it comes to running a business. For this reason, it’s hard to say whether debt financing or equity financing would be better for your unique situation.
However, you may want to consider debt financing if…
- You qualify for the different types of debt financing that are usually meant for more established businesses.
- You’re able to put up collateral such as your house or your car for funding and are comfortable with taking that risk.
- You’re playing the long game and want to retain full ownership of your business so that you can fully enjoy the profits down the road instead of having to split them with investors.
On the other hand, you may want to consider equity financing if…
- You have a brand new startup business that’s not yet profitable but very well could be with the right funding and support.
- You don’t mind giving up a portion of your business and would be happy to have a “partner” in your business endeavor that you can go to for questions, guidance, and advice along the way.
- You don’t want to take on any debt that could potentially hurt your business since you’re required to make regular payments on both the loan’s interest and principal.
How to Secure Debt Financing?
If you want to secure debt financing, you need to make sure that your finances are to qualify. This means having a good credit score and no history of missed payments, defaults, or bankruptcies. This also means reducing your debts to qualify for larger loan amounts. At the same time, reducing your debts can also boost your credit score — so it’s a win-win situation.
If you want to secure debt financing, you also need to be comfortable and willing to provide collateral. For instance, you may have to sign over your house, car, or other assets to the lender. If you’re unable to repay the loan, the lender would then take possession of these assets.
How to Secure Equity Financing?
If you want to secure equity financing, you need to locate potential investors. You can find angel investors, venture capitalists, and crowdfunding platforms online if you know where to look. From there, you need to create a solid business plan and pitch — making sure to include all the numbers and information that investors are looking for.
Here are some different components you should have in your pitch to potential investors:
- Problem identification
- Your solution to the problem
- Target market and customers
- Competitor analysis
- Unique value proposition
- Business model
- Team
- Ask
Final Thoughts on Debt Financing vs. Equity Financing
As you can see, there’s no such thing as free money. Both debt and equity financing come with a unique list of pros and cons that only you can weigh for yourself. However, if you need additional guidance in the business world and don’t want to sign over a portion of your business to get it from a venture capitalist, reach out to business growth experts like Greg Gillman.
Sources:
Debt vs. Equity Financing: What’s Best for Your SMB? | Businessnewsdaily.com
Debt vs. Equity Financing: What Option Is Best for You? | NerdWallet
