Debt vs. Equity Financing: Which One Is Right for You?
rowing a small business can be tricky, even if you have an innovative product and a surefire business plan. One of the biggest obstacles you'll face is raising money as a small business, since you may not have the revenue, capital, or assets to fund your operations yet. Debt and equity financing can be viable options to scale a small business, but you should carefully consider your choice.
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What is debt financing?
Debt financing refers to what probably comes to your mind when you think of business credit. It includes different types of business loans and business lines of credit.
Debt financing works similarly to personal business loans: You borrow a certain amount and agree to pay it back in monthly installments. This includes a finance charge, commonly known as the interest rate or annual percentage rate (APR). Over the term of the loan, you'll be paying back the initial amount plus the interest that accrues.
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Benefits of debt financing
Debt financing can be a great way to grow your business as it offers flexibility to help you invest your money where you see fit. These are some of the top benefits of debt financing for small businesses.
No need to give up control of the business
One of the biggest benefits of getting a loan is that you can decide what to do with the money. As a small-business owner, nobody understands your business as well as you do. That鈥檚 why getting a loan is a popular way to fuel growth in the initial stages since you don鈥檛 have to run your decisions by stakeholders or investors.
Interest is tax-deductible
In general, any interest you pay on your business loans is . This means you may be able to write off most or all of the costs associated with debt financing, making it a low-cost way of obtaining funding.
However, whether your interest is tax-deductible depends on the type of loan you obtain and what you use the funds for. If you鈥檙e not an expert in filing taxes for your small business, then it鈥檚 best to consult an accountant or a tax professional to determine whether your loan interest is tax-deductible.
Payments do not fluctuate
You'll receive a contract with all of the terms and conditions when you're approved for a loan, including the repayment schedule, your APR, and any additional fees. This will give you a solid idea of what your monthly payments will be like for the duration of the loan, which can help you plan ahead.
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Downsides of debt financing
Debt financing isn鈥檛 always the way to go for small businesses. Here are some of the biggest downsides.
Qualifying for a loan may be difficult
Lenders will look at your business鈥檚 income statements, balance sheets, cash flow statements, and other financial documents to assess your ability to repay the loan. This makes it difficult for new businesses and those struggling with cash flow problems to get approved for such financing. In fact, less than half of all small businesses in the U.S. think that their .
Payments start right away
Generally, loans require businesses to start making payments within 30 to 45 days after receiving a new loan. This means you may not have enough time to generate a return on your investment before you're required to make payments on your loan.
Puts assets at risk
Defaulting on a business loan can put your business at risk, especially if you obtained a secured business loan. For example, you may be able to obtain a loan if you put up your delivery truck as collateral. However, this means the lender may be able to repossess the truck if you stop making payments.
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What is equity financing?
Equity financing involves selling a percentage of your company to raise capital. With equity financing, an investor will pay you a sum of money in exchange for shares in your company, or a percentage of ownership.
For example, let鈥檚 say you want to raise $10,000 through equity financing. In that case, you would have to look for an investor willing to pay $10,000 for a portion of your company. You would then negotiate with the investor to find a percentage of your company that is appropriate for the amount of money you're asking for.
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Benefits of equity financing
Equity financing offers several benefits, especially for companies looking to scale quickly. Here are some of the top benefits.
No repayment obligations
Unlike debt financing, equity financing doesn鈥檛 need to be repaid. This can be especially helpful for new businesses that are looking to reinvest as much money as possible into their growth, as they won鈥檛 be saddled with debt.
Easier to qualify for startups
Loan providers will look at financial statements to assess a company鈥檚 ability to repay a loan when deciding whether to extend credit. Investors, however, will look at a company鈥檚 product, business plan, and growth strategy when deciding whether to invest in the business. This means it鈥檚 easier to obtain equity financing for startups with a limited financial track record but a solid growth plan.
Partner with an experienced mentor
Finding an investor is a more intimate experience than finding a lender. While a lender is simply interested in your company鈥檚 ability to repay the funds, an investor will be interested in seeing your business succeed. This means partnering with the right investor can open the door to new suppliers and larger networks that can help you grow your business even faster.
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Downsides of equity financing
Equity financing isn鈥檛 the right choice for all businesses. Here are some of the most common downsides.
You give up a part of the business
Obtaining equity financing means you're giving up a portion of your business. While this financing can help you grow the business during a critical period, it also means you might miss out on a lot of value if your business succeeds.
For example, let鈥檚 say you sell 10% of your business for $10,000. After one year, you鈥檝e managed to grow the value of your business to $200,000. This means the 10% share you sold for $10,000 is now worth $20,000, so you鈥檝e lost out on $10,000 of added value.
That's why it's important to know what the difference is between debt financing and equity financing. In the example above, you may have been able to obtain a $10,000 loan with a 10% APR. If you were to repay the loan in three years, then you'd be paying a total of $1,616.19 in interest, which is significantly lower than the $10,000 loss of value in the equity financing scenario.
More time-consuming
Finding investors can be time-consuming, even for the most brilliant entrepreneurs. Even when you do find investors who are willing to take a chance on your business, the negotiation process can take weeks or even months. This means you won鈥檛 be able to get your financing immediately, whereas business loans are often approved within the same day.
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Which option will work best for my small business?
Deciding between debt vs. equity financing depends on the circumstances of your business. In general, small businesses with a solid financial track record can benefit the most from debt financing, while small businesses with a promising growth strategy can do better with equity financing.
海角爆料 Funding is another excellent option for small businesses looking for funding. to see if you qualify for financing of up to $75,000.
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