For companies in the beginning stages of development, they need outside money for growth or other purposes. There are two basic types of funding available to small businesses—debt financing and equity financing. As a small business owner, which is best for you?
What is Debt Financing?
When you take a personal or bank loan to fund your business, it is a form of debt financing. When you debt finance, you not only pay back the loan amount but you also pay interest on the funds. Purchasing a home, buying a car, or using a credit card are all also forms of debt financing. The advantages of debt financing are numerous. First, the lender has no control over your business. Once you pay the loan back, your relationship with the financier ends. Next, the interest you pay is tax-deductible. Finally, it is easy to forecast expenses because loan payments do not fluctuate.Debt is an expense, and you have to pay expenses regularly. This could put a damper on your company’s ability to grow.
What is Equity Financing?
The main difference between equity financing and debt financing is that equity financing involves investors. You could offer shares of your company to family, friends, and other small investors, but equity financing often involves venture capitalists or angel investors. The significant advantage of equity financing is that the investor takes all the risks. If your company fails, you can avoid paying the money back. You will also have more cash available because there are no loan payments. Finally, investors take a long-term view and understand that growing a business takes time. The downside is significant. You will have to give the investor a percentage of your company to gain funding. You will have to share your profits and consult with your new partners whenever you make decisions affecting the company. The only way to remove investors is to buy them out, which will likely be more expensive than the money they initially gave you.
Debt Financing VS Equity Financing
- Easier for a mature business to get
- Quicker way to get cash
- Typically ranges from $1,000 to $100,000
- Money must be repaid with interest
- Investor typically does not receive share of profits as part of the deal
- Small business does not give up share of ownership
- Investor likely will not demand a seat on the company’s board
- Easier for a startup to get
- Usually a slower way to get cash
- Equity financing typically ranges from $200,000 to millions of dollars
- Money does not need to be repaid
- Investor typically receives share of profits as part of the deal
- Small business gives up share of ownership
- Investor may demand a seat on the company’s board
What is more expensive? Debt or Equity Financing?
Debt financing is cheaper than equity financing primarily because interest on debt can be written off on a business’s tax returns, while equity financing can’t be written off.
What is Better for My Business, Equity or Debt Financing?
The rewards of using equity or debt financing to fund your start-up costs depend on how much money you need and the size of your business. Traditional equity financing is challenging to secure, especially for small, early-stage startups. Often you will not have a choice. Venture capitalists are usually looking for companies with a global reach. Angel investors, those who fund on a smaller scale, are often looking to invest approximately $600,000 in new startups, but if you search for them, there are angel investors who also invest less.If your company is a startup serving a local market and does not need large-scale funding, debt financing is probably your best, and perhaps only, option. More prominent startups often combine debt and equity financing to reduce the downside of both types.
What will you choose? Debt or Equity Financing?
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