For most entrepreneurs, financing options are limited to either debt or equity. Weighing the two options at each stage makes all the difference between staying afloat or sinking in the ocean of liquidity challenges.
We compare the upside and the downside of these financing options to help you make an enlightened decision. On one hand, debt financing for entrepreneurs who are just starting out attracts high, unaffordable interest rates that drive them under.
However, equity financing might bring on board an investor who has a different vision for the company, making it an unhappy marriage driven by bad decisions.
There are a few factors to consider before settling on either option to ensure you choose the right fit for you as an entrepreneur.
Understanding Debt Financing
Debt financing involves borrowing a fixed sum from a lender which is then repaid with a predetermined interest rate. It is essentially a loan a lending institution such as a bank, your parents, or acquaintances give you and is paid back plus interest.
There are different options when it comes to debt financing including:
- Secured credit line
- Credit cards
- Invoice financing
- Merchant cash advance
You might be required to put up an asset as surety, collateral, or a guarantee to assure the lending institution you will not default on payment.
Debt Financing Pros
- Control and ownership: Debt financing allows entrepreneurs to retain complete ownership and control. The bank, or lending institution, claims only the loaned amount and agreed interest, thus they neither get a stake nor control over your venture.
- The lender cannot claim any future profits, they can only claim repayment of principal and interest agreed upon beforehand. This means all profits go to the owners.
- You can reduce the same day loan expense if it is deducted from the venture’s tax returns.
- It is easy to plan for repayment of debt financing loans.
- There are many options to choose from. Entrepreneurs can apply for cards, loans, or lines of credit.
- Low interest rates
- It is easy to acquire debt capital because it is governed by fewer regulations.
- It is suitable for businesses of all sizes.
- Flexibility regarding the amount of money you can borrow and the repayment duration.
- Debt must be repaid whether the venture succeeds or not.
- You risk losing the assets used as collateral upon default.
- The loan and interest repayments are a fixed cost which raise the company’s break-even point increasing the cost of business and limiting growth.
- Loans are often repaid in fixed amounts which requires cash flow. This might be difficult for young ventures.
- Some debt financing instruments restrict entrepreneurs from pursuing other financing options and how you use the loan.
- Debt prevents you from ploughing your profits back into the business.
Understanding Equity Financing
Equity financing involves putting up a chunk of the business shares or ownership and in exchange you get investment or capital. The two types of investors are venture capitalists or angel investors. Equity financing has been a major source of investment for some sectors such as tech startups.
The best part is you’re not required to start making repayments on equity financing before your business is profitable. However, equity investors expect a share of your profits as long as the business is operational and profitable. This changes if you make enough to buy them out.
Pros of Equity Financing
- You’ll have access to seasoned and experienced investors with industry connections, therefore increasing your chances of success.
- There is no money spent outside your business which allows you to plough back the profits into the business.
- The financial risk is shouldered by the investor. Although you don’t have to make repayments when not making profits the investor is heavily invested in your success.
- Shared ownership and control of the company. The investor must be involved in every decision affecting the business.
- Finding an investor who shares your visions and goals takes time.
- You might not agree on how the business should be run.
- To get equity financing you have to be compliant with numerous laws and regulations.
- You are required to present periodic reports to the investors and shareholders.
- The ending of equity financing is unpredictable
Which one is for you?
Debt and equity financing are both excellent options and tips for entrepreneurs at different business stages. It is prudent to explore and consider both before settling on one choice.
Consider the long-term impact of both financing options on your business. Some factors to consider include:
- The impact of a loan on cash flow
- Capital costs
- How the costs impact business growth
- Sustainability of the cost
- The ability of your company to take debt
- The company lien
- Can you afford to lose the guarantee if you are unable to repay the loan?
- If you are considering equity, what will it cost?
- Which rights you are willing to give away
- How much control you will hand over to equity finance investors
- Value addition and the ability to work alongside the investors.
Which financing method is best for you?
Before opting for debt financing, your business must have profitable operational history. You must also be able to prove to the lender your ability to make enough revenues to make payments. On the other hand, equity is risk free to the entrepreneur. However, the downside of this is the investor will get a share of your profits until you can buy them out.
Equity financing might also take longer than debt financing. For an entrepreneur who needs immediate cash injected into the business, debt financing is the best option. You can get approved within hours by some lenders.
Since equity financing takes time, you have to look for investors, sit through several meetings while pitching them and it could take weeks to finalize the legal documents.
As an entrepreneur, it is important to consider how much capital need to start your business. Small amounts are usually easier to get through debt financing. Equity financing is better for larger amounts because it comes with investor backing who has years of industry knowledge and connections.
They are also likely to give you guidance and advice on the best way to utilize the capital, to ensure they get returns on their investment.
You might also want to consider what your business needs at this point. Sometimes money is not enough. If you need an insider’s knowledge and are in search of establishing a beneficial relationship that will significantly boost your enterprise, equity financing is best for your business.
One-size-fits-all solutions don’t exist in debt or equity financing. However, understanding what you need and when, might help in making an informed decision.
Carefully consider all the factors, advantages and downsides associated with both financing options. Choose the option that is most beneficial to your business. Alternatively, you can consider using both as your business grows.