I get a lot of questions from companies whether they should use debt or equity to finance their growth. Business owners contemplate this critical question as they look for financing. Which alternative is best?
The advantages to debt financing are numerous. First, the lender has no control over your business and does not have any ownership. Once you pay the loan back, your relationship with the financier ends. Next the interest is tax-deductible. Finally, it is easy to forecast expenses because loan payments do not fluctuate.
The disadvantages to debt financing is that the money must be paid back within a fixed amount of time. Debt is a bet on your future ability to pay back the loan. What if your company hits hard times or the economy, once again, experiences a meltdown? What if your business does not grow as fast or as well as you expected? Debt is an expense and you have to pay expenses on a regular schedule. This could put a damper on your company’s ability to grow. And the assets of the business can be held as collateral to the lender along with the owner of the company is often required to personally guarantee repayment of the loan.
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 the 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 investor.
The advantages to equity financing is that the investor takes all of the risk. If your company fails, you do not have to pay the money back. You will also have more cash available since there are no loan payments. Investors take a long-term view, and most don’t expect a return on their investment immediately.
The disadvantages to equity financing is that you will have to give the investor a percentage of your company. You will have to share your profits and consult with your new partners any time you make a decision affecting the company – and you may disagree with your investors. The only way to remove investors is to buy them out, but that will likely be more expensive than the money they originally gave you.
The Bottom Line
The type of financing you seek depends on your startup. If you are just getting started, consider a loan from family, friends, borrowing against a 401K or IRA or from a bank if you qualify. There are micro financing companies that will loan up to $30k unsecured depending on your personal credit and some alternative funding options available for financing of purchase orders, accounts receivable and equipment. As you grow and reach a larger market, equity funding may become a more viable option if you are willing to give up a portion of your company. A lot of businesses opt for a blend of both debt and equity financing to meet their needs when expanding a business. The two forms of financing together can work well to reduce the downsides of each.
If you are in need of debt or equity financing, Alternative Funding Options can help connect you to the right funding source.