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Debt vs. Equity Financing: Which Is the Best Way for Your Business to Access Capital?

The focus of your business changes once you have moved beyond the start-up stage; growth becomes the priority for ensuring the enterprise’s sustainability. This article discusses the two major and most common categories of financing available to businesses pursuing growth; debt and equity financing, and highlights some of the pros and cons of each.

Debt Financing

Debt financing typically involves funding your business by borrowing money from banks, commercial finance companies, and other financial institutions in the form of a loan. Loans can even be sought from individual lenders such as shareholders, family, friends, officers, and directors.

Companies which are relatively well established, have a steady sales history (that is likely to continue), an excellent credit history, substantial collateral to offer and profitable growth patterns tend to rely on debt financing to fund their businesses.

Debt financing is often accompanied by strict covenants or conditions in addition to the specified dates on which the interest and principal amounts have to be paid. Severe consequences can ensue in case of failure to meet the debt requirements. However, you do not give up ownership of your business in debt financing. Furthermore, borrowers must prove to potential lenders that they are willing to invest their money into the business as well.

Most loan arrangements are subject to loan agreements, guarantees, and promissory notes. Contrary to popular belief, there is no such thing as a standard loan agreement. Business owners can negotiate virtually all terms in any loan taken for their corporations, which is a major advantage of this mode of financing.

A firm may also raise money for working capital and/or capital expenditures by selling bills, bonds or notes to individual and/or institutional investors. In exchange for the money lent, these individuals and institutions thereby become creditors of the business and are promised the repayment of the principal amount with an additional interest charge.

Most small business owners tend to be hesitant about debt financing as the uncertainty that their business’s cash flow situation poses renders them unable to personally guarantee timely repayment of the debt. Inadequate credit-worthiness to qualify for a bank loan is another major concern; thus most small business owners don’t even bother to apply.

Advantages:

  • With debt financing, there is no dilution in ownership of the business as you retain full control of your business.
  • Lenders have no claims to future profits made by the company.
  • Small business loans range from short to long-term and usually include a 6-month grace period before repayment is due.
  • Although you may be required to provide tangible assets as collateral to back up your loan in case you default, you do not lose creative and strategic control of your business.
  • Furthermore, taking debts can help build your business credit, a factor which can immensely help your business’s future borrowing needs as well as positively affect insurance rates.
  • Lastly, the interest you pay on a loan is tax-deductible which softens the blow of the repayment to some extent. This means that if your company is profitable, the effective interest cost is less than the stated interest charge.

Disadvantages:

  • Repayment of the loan is not tied to the success of your business; it has to be repaid no matter what.
  • There is usually unlimited liability; not only your business’s but also your personal assets are also liable in case of default.
  • Interest rates for loans can be extremely high, driving up business costs.
  • In some cases, early repayment can lead to the imposition of fines.
  • Adding too much debt can increase your company’s future cost of borrowing as well as add unwanted risks for the business.

Equity Financing

Equity financing, on the other hand, involves bringing in or attracting partners and/or investors who provide capital/funds in exchange for ownership of the business, generally with the expectation to make a profit when the business becomes successful.

Through equity financing, funds can be secured through venture capitalists, bootstrapping, friends and family, government-backed community development agencies, investment banking firms as well as angel investors.

Unlike a loan, business owners are usually not required to pay back the investors in case their company doesn’t make a profit; this also enables them to free up significant working capital for the business as there are no monthly loan payments.

Furthermore, equity financing is an attractive and feasible option for many small business owners because it doesn’t require a very solid financial history to be eligible for a loan, although partners or investors will need some assurance regarding the earning power of the business.

This serves as a crucial point for most small to medium business owners, especially those who have just recently started and do not have two or three years worth of financials that most banks demand.

Advantages:

  • Acquiring new partners can prove extremely beneficial to your business. A strong, smart partner, especially one who complements your leadership skills can be a real asset to your business.
  • This also helps to achieve a balance in the management of your business. For instance, if you’re the visionary type with lots of creative ideas, you may benefit from the influence of a partner whose main concern is economy and cost reduction.
  • Unlike a loan, there are no monthly payments.
  • It makes for a great option for a business that lacks adequate collateral to secure a loan.

Disadvantages

  • The major cost of the aforementioned benefits of the loss of sole ownership/control of the business.
  • This also means that not only are you investors entitled to their share of profits, but they also have a say in how you run your business and the direction in which it is headed.
  • Although it may not seem like a problem in the early stages when finances are required, the acquisition of new partners/owners can lead to conflicts and disagreements down the road.

Striking A Balance

There is no hard and fast rule that you have to choose a single method of financing; businesses can reap the benefits and eliminate the drawbacks of both the aforementioned sources by opting for a combination of the two.

However, it is essential that you maintain an optimal debt to equity ratio. Over-dependency on debt for financing can result in lower profits and thus lower dividends for shareholders (as you regularly incur high-interest costs). This can create difficulties in securing future funding for your business because lenders want their money to be utilized in your business, not in paying off your loans. An ideal situation would be where shareholders have more money invested in the business as opposed to lenders and creditors.

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