Most businesses cannot get by, especially at the start, without financing from an outside source. But finding outside money is not always straightforward and deciding between different options can be tricky.
For most businesses, there are two types of funding available: debt financing and equity financing. This guide will look at the benefits, as well as the disadvantages, of both and how you can find the right option for your business.
- 1 THE OPTIONS EXPLAINED
- 2 THE ADVANTAGES & DISADVANTAGES OF DEBT FINANCING
- 3 THE ADVANTAGES & DISADVANTAGES OF EQUITY FINANCING
- 4 HOW TO DECIDE WHICH FUNDING OPTION IS BETTER FOR YOUR BUSINESS
- 5 THE BOTTOM LINE
THE OPTIONS EXPLAINED
Before we begin analyzing the benefits of both debt and equity financing, it’s important to explain the basics of these two common types of funding.
What is equity financing?
Equity financing means the business raises money by selling a specific amount of shares in the business. Friends and family can provide the financing, but in the business world, it most often involves professional investors.
When the investor gives the business the money, they get a part of the business and therefore, become partial owners of the business. This gives them access to a share of the business’ profits and could provide certain rights in terms of decision-making. The money raised through equity financing won’t need to be paid back to the investor immediately. In addition, paying back the investment is often tied into the business’ ability to make money. This means a business doesn’t necessarily have to pay dividends unless it is generating enough money.
As mentioned, small businesses can attract equity financing from friends and family at the start of the business. But later on, professional investors, such as venture capitalists and angel investors, are often the best source for equity financing.
An example of equity financing
Business A has been able to attract $500,000 of equity financing from investor B. In exchange for the money, investor B gets a 25% stake in the company. Over time, investor B will be able to share in on the profits of the business. He can later sell his part of the business, 25%, back to the owner.
Notice that when investor B sells his share back, the owner is likely going to have to pay more than the $500,000, depending on the business’ current valuation.
What is debt financing?
Debt financing is often a better-understood concept. It simply means borrowing money from an outside source, with the money being paid back at an agreed date together with interest. The payment is often made in installments and the need to pay back doesn’t change depending on how much money the business makes.
In addition to paying back the borrowed amount, businesses typically must also make interest payments, which are pre-agreed. Traditionally, banks and other financial institutions provide debt financing. In addition to this, businesses can also attract debt financing from friends and family, as well as different small business organizations. For instance, governments often provide special debt financing schemes for start-ups and small businesses.
In debt financing, the institution or person borrowing the money won’t receive a share in the business.
An example of debt financing
Business A has been able to obtain a $500,000 loan from bank B. They have agreed business A has to pay monthly installments with 10% annual interest payments. Bank B won’t have any ownership in the business, but business A has to start repayments immediately and keep servicing the debt regularly.
THE ADVANTAGES & DISADVANTAGES OF DEBT FINANCING
Since debt financing tends to be better understood, let’s look closer at the advantages and disadvantages of raising debt.
The advantages of debt financing
One of the biggest benefits involves the ownership of your business. Since debt financing doesn’t involve you giving out a share of the business in return of it, you can continue to run your business as you want. This is naturally a great way to maintain control of your business, but it can also make the process of running the business smoother.
Your lenders do not influence the ownership unless you can’t keep servicing the debt. You’ll understand the difficulties that might arise from problems in repayment in more detail in the next section.
As well as being able to run your business independently, you also won’t need to worry about the relationship to the lender too much. After you’ve paid your debt, your relationship will end and your lender won’t be involved with the business anymore.
Furthermore, the financial benefit of raising debt can be apparent when you do your taxes. The interest payments you make on the debt are in most cases tax deductible. This can be a big advantage for start-ups and small businesses. In addition, you know the timeline in advance, which can help your business to plan its expenses more appropriately. You won’t need to worry about sudden additional payments, as any changes would have to be discussed and approved well in advance.
Finally, while the financial situation in many countries remains challenging, debt financing can be easier to obtain than equity financing. If you are already dealing with a commercial bank, obtaining a business loan might not be too difficult. Depending on how much money you need, finding a bank or a governmental organization to loan you money can be straightforward. In addition, the actual application process for achieving a loan can be relatively simple and won’t require a lot of negotiating.
If you are able to service your debt accordingly and on time, you might use it as a tool to build up your business credit score. This can be beneficial in terms of attracting future loans, with better interest rates and terms.
The disadvantages of debt financing
But there are certain downsides to debt financing. The biggest problems often arise if you are having trouble servicing the debt. Servicing the debt can be difficult for a small business, especially as many lending institutions require you to start installments relatively soon from lending the money.
For a small business and a start-up, having a steady and immediate cashflow won’t be too easy. Renegotiating a better timetable for the installments can be difficult. Furthermore, the money you need to spend for servicing the debt can mean your business limits its growth potential. The cashflow you generate can’t be fully used for increasing growth, as you often can’t take a break from your repayments.
Even if your business is able to make the repayments on most months, a single bad month, in terms of sales, can negatively impact your debt servicing. This can add additional stress, not just on your business finances, but also on your wellbeing.
As mentioned above, if you run into problems servicing the debt, you can start losing business assets. This could potentially mean the end of your business. In addition, many business loans require you to be personally responsible for the repayments. This means you might have to put your personal assets on the line to obtain the loan. If you can’t repay your debt, you might not just lose business assets, but also your personal assets.
While debt financing can in some cases boost your business’ future fundraising opportunities, it can also have the opposite effect. If your business has a lot of debt, it can be a hindrance in terms of finding future investments. Raising capital can be difficult, as bigger debt ratio can turn down many potential equity investors.
THE ADVANTAGES & DISADVANTAGES OF EQUITY FINANCING
Now that you understand the benefits and problems with debt financing, it’s time to look at equity financing. Like debt financing, raising equity can have big benefits, but also major drawbacks for your business.
The advantages of equity financing
Perhaps the biggest advantage of equity financing is the ability to add more working capital for your business. If you are running a start-up or a small business, the increase in working capital can be an important part of generating more growth.
The reason equity financing adds more capital is due to it not being tied down to a quick repayment schedule. You aren’t required to make any additional interest payments and you only need to repay once your business can actually afford it. Therefore, you won’t be taking away money from your sales, but can focus your efforts on growing the business. You’ll only need to repay, once the business is making enough profits.
The repurchase of the share can therefore start a lot later than repayments with debt financing. This can be extremely beneficial for new businesses, as you can use early profits for growing the business and thus ensuring bigger returns in the future.
In addition, the investor is taking a risk by investing equity into your business. If your business doesn’t start making money, you don’t have to repay the equity for the investor. It is essentially a less risky option for you as a business owner, since you don’t stand to lose business or personal assets.
Finally, equity financing often involves professional investors, who can provide a wealth of other benefits to your business outside cold hard cash. As the investors become a part of your business, they can help mentor you towards better business decision. The wealth of information you can gain from the right investor can be worth more than money.
Investors don’t just bring in their personal expertise; you can make further connections by having an investment company or a personal investor involved in your business. This can make future fundraising rounds a lot smoother.
The disadvantages of equity financing
The biggest drawback to equity financing might sound a bit counterintuitive, especially considering the above. While you aren’t required to pay interest on your equity financing, the cost can still end up being higher than in debt financing, both in terms of pure money, but also the ownership of your business.
First, finding the right investor is not easy and drawing up the term sheet can cost both money and time. Furthermore, the investor will take a certain amount of your business’ profits, as they take ownership in your business. The ownership is typically around 10% to 20% of the business. Since the investor owns part of your business, you can’t end the relationship other than by buying them out. The process to do so might end up costing you more than what the investor initially invested.
The second costly drawback is the loss of authority. The investor will share the ownership of the business and therefore, have a say in how the business is run. You’ll have to consult and inform the investor over decisions and you might end up finding yourself disagreeing over certain strategies. Although investors can bring a lot of experience to your business, they can also see the future of your business differently.
Finally, obtaining equity financing can be harder than debt financing. While there are plenty of investors out there, finding the right one for your business is not an easy process. Not only do you need to make sure your business is attractive to the investor, you also need to pick an investor, who share’s your vision and strategy for growing the business.
HOW TO DECIDE WHICH FUNDING OPTION IS BETTER FOR YOUR BUSINESS
Considering how both financing options have plenty of lucrative advantages, as well as disadvantages, on their side, picking the best option for your business can seem difficult. The truth is, it is. It is nearly impossible to say which funding option is better, as the decision always depends on the individual circumstances of your business. Nonetheless, you should keep a few guidelines in mind when selecting your business financing.
Think what type of business you have
The right financing option can depend quite a bit on the type of business you have. First, start-ups are not all the same and different financing options can benefit start-ups differently.
The essential question deals with your start-ups ability to create revenue. If you are a start-up working in traditional industries, such as retail and manufacturing, you are more likely to start generating a steady revenue stream right from the get-go. Therefore, debt financing can be quite a good option for your business, as repaying the loan won’t be too big of a problem.
On the other hand, if you are a start-up working in a higher risk industry, such as technology or other innovation sector, obtaining a loan might not be as good idea. If you aren’t able to make money immediately, getting a loan can be costly and expensive. Even attracting it without a clear revenue stream can be difficult.
Second, small businesses, which have been operating for a while, need to consider the financing options through their future strategy and current finances. If your business credit score is good, debt financing can be a good option for your business. It also depends what you want to do with the money. If you are simply looking to grow your business quickly and take it to the next level, getting an investor on board can prove to be more beneficial.
The attractiveness of your business to either option
You also have to think about how attractive your business is for either financing option, i.e. how easy will it be to raise either debt of equity. Raising money won’t happen in a day and you need to take some time out from running the business; you, therefore, don’t want to be running after impossible options.
As mentioned above, if your business has a good credit score and you can easily demonstrate a future revenue stream, obtaining a loan might be much more straightforward. This is partly because investors, in most cases, aren’t looking for ‘safe’ options. Investors are after companies and ideas that can provide big returns for them in the future. Investors are therefore investing with a long-term aim in mind. If your business plans are local and small key, equity financing might not be the right option for your business, as attracting it will be difficult.
The option of convertible debt
There is also a third option for financing a business. Convertible debt is a financing option that uses a combination of debt and equity financing.
If you are financing with convertible debt, you are essentially borrowing money from investors. The money will then be either repaid or turned into a share in the company in the future, the specific timeline is pre-agreed with the investor. The repayment or share acquisition takes place typically either once the business is raising more money or once it has reached a certain valuation.
For further information on convertible debt, check out the below YouTube video:
Convertible debt can be a good option for start-ups, which aren’t yet set for a proper business valuation. If the business isn’t mature enough to attract pure equity financing, then convertible debt can be a great option. It’s also often easier than attracting debt financing at this point, since the business is unlikely to have a clear revenue stream.
THE BOTTOM LINE
Finding the right financing option for your business depends heavily on the type of business you are running. The advantages and disadvantages of both equity and debt financing are either enhanced or highlighted depending on your business.
In general, traditional businesses that are able to start generating a steady cashflow from the onset can benefit more from debt financing. On the other hand, risky and innovative businesses can find it easier to look for equity financing. You need to carefully consider what are your needs for the money and what type of financing is easier for your business to obtain.
Essentially, debt financing can cost more to your business in the short-term. Therefore, you need to be able to appropriately service the debt, even as you try to grow your business. On the other hand, equity financing is more expensive in the long-term.
Most often, you might not have much of a choice, as your business’ attractiveness to either option plays an important role in the decision-making. If your business has no credit score, most institutional lenders won’t borrow. Therefore, you need to look at your business through the eyes of an outsider.
For many businesses, the best option is to opt for a combination of both. You can get started by borrowing a little from your friends and family, while raising equity from start-up investors later down the line.