Whether you're preparing to launch a startup or want to grow your business, one thing is for certain: You’re going to need money. Debt and equity financing are two different financial strategies: Taking on debt means borrowing money for your business, whereas gaining equity entails injecting your own or other stakeholders’ cash into your company.
Business owners may have some trepidation about borrowing from a financial institution, as it means relinquishing some cash profits. But it could be a good option so long as you expect to have sufficient cash flow to pay back the loans, plus interest. The major benefit for debt financing, unlike with equity financing, you'll retain full ownership of your business. The interest on business loans is also tax-deductible, and you’ll build your credit.
Small businesses frequently take bank loans. They are usually easy to obtain – so long as you have good credit, enough equity to cover the payments and you're not already carrying heavy debts. These loans are generally granted either on a short-term basis of less than one year or long-term basis of more than one year.
If you want to raise $100,000 or less, you may be able to receive a bank loan based on your personal credit. This is called an unsecured loan. Secured loans are granted in larger amounts. Banks usually expect you to put up assets to back the loan. These assets could include property, your personal investments, equipment or other tangible holdings that the bank could seize if you default on the loan.
Commercial finance companies also lend money and are willing to fund riskier ventures that don't have solid financials. But this type of funding usually comes with high interest.
Small business owners when weighing debt and equity financing options often opt for equity financing because they have concerns about either qualifying for a loan or having to channel too much of their profits into repaying the loan. Investors and partners can provide equity financing, and they generally expect to profit from their investments. No debt payments means more cash on hand. Moreover, if no profit materializes, you aren’t obligated to pay back equity contributions.
The major drawback of equity financing is that you are no longer the full owner of a business once you have other financial contributors who expect a share. As such, you will be relinquishing not just financial control, but will no longer be the sole arbiter of the business’s creative and strategic direction.
There are also so-called angel investors: wealthy individuals or networks that are willing to fund small businesses. Angels are the largest source of seed and start-up capital for businesses, investing $25.6 billion in businesses in 2006, according to the Center for Venture Research at the University of New Hampshire. Angel investors tend to fund small businesses for longer periods of time and expect a lower return on investment than do venture capital firms.
Venture capital firms, on the other hand, provide equity for businesses and expect high returns on their investments within three to five years. They generally fund companies with significant growth potential -- Microsoft and Google attracted VC funding -- not small businesses.
Most businesses have a mix of debt and equity financing. Too little equity could prevent you from securing or repaying loans, while carrying little or no debt could indicate that you are too risk-averse, and that your business might not grow as a result. Check with your industry association to find the average debt-to-equity ratio for your sector.