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

Date: October 17, 2009

Deciding between equity financing and taking on a loan for your business is a challenge for all  small business owners when they need capital to expand a business. Should you go to a bank and apply for a business loan? Or should you look for an investor?

Consider the advantages and disadvantages of each to determine which type of financing is best for your business:

Equity financing

Having an investor write you a check may seem like the perfect answer if you want to expand your business but don't want to take on debt. After all, it's money without the hassle of repayment or interest. But the dollars come with huge strings attached: You must share the profits with the venture capitalist or angel investor.

Advantages to equity financing:

  • It's less risky than a loan because you don't have to pay it back, and it's a good option if you can't afford to take on debt.
  • You tap into the investor's network, which may add more credibility to your business.
  • Investors take a long-term view, and most don't expect a return on their investment immediately.
  • You won't have to channel profits into loan repayment.
  • You'll have more cash on hand for expanding the business.
  • There's no requirement to pay back the investment if the business fails.

Disadvantages to equity financing:

  • It may require returns that could be more than the rate you would pay for a bank loan.
  • The investor will require some ownership of your company and a percentage of the profits. You may not want to give up this kind of control.
  • You will have to consult with investors before making big (or even routine) decisions -- and you may disagree with your investors.
  • In the case of irreconcilable disagreements with investors, you may need to cash in your portion of the business and allow the investors to run the company without you. 
  • It takes time and effort to find the right investor for your company.

Debt financing

The business relationship with a bank that loans you money is very different from a loan from an investor -- and requires no need to give up a part of your company. But if you take on too much debt, it's a move that can stifle growth. 

Advantages to debt financing:

  • The bank or lending institution (such as the Small Business Administration) has no say in the way you run your company and does not have any ownership in your business.
  • The business relationship ends once the money is paid back.
  • The interest on the loan is tax deductible.
  • Loans can be short term or long term.
  • Principal and interest are known figures you can plan in a budget (provided that you don't take a variable rate loan).

Disadvantages to debt financing:

  • Money must paid back within a fixed amount of time
  • If you rely too much on debt and have cash flow problems, you will have trouble paying the loan back.
  • If you carry too much debt you will be seen as "high risk" by potential investors – which will limit your ability to raise capital by equity financing in the future.
  • Debt financing can leave the business vulnerable during hard times when sales take a dip.
  • Debt can make it difficult for a business to grow because of the high cost of repaying the loan.
  • Assets of the business can be held as collateral to the lender. And the owner of the company is often required to personally guarantee repayment of the loan.

Most businesses opt for a blend of both equity and debt financing to meet their needs when expanding a business. The two forms of financing together can work well to reduce the downsides of each. The right ratio will vary according to your type of business, cash flow, profits and the amount of money you need to expand your business.

NEXT >> COMMON MISTAKES ENTREPRENEURS MAKE IN THE SEARCH FOR CAPITAL


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