When small-business owners need extra capital to grow and scale their company, it can be a challenge to figure out which type of financing is the best fit. Should you take out a business loan or look for an investor? Before making this important decision, it’s important to consider the key differences between debt and equity financing.
Debt Financing
In simple terms, debt financing – or a “term loan” – involves borrowing money from a lender under the expectation that it will be paid back within a certain timeframe, plus interest, with the principal fully amortizing over that term. If you’ve ever taken out a loan from a bank, you have financed something with debt. Unlike equity financing, it doesn’t require you to give up a portion of your company to an investor. However, if you acquire too much debt, it can stifle the growth of your small business.
Pros:
- Lender has no ownership in your company and, therefore, no say in how your business is run
- Full control over how the capital is spent
- Lender-business relationship ends once the loan is paid back
- Offers flexibility in type and length of the loan
- Interest on the loan is tax deductible
- Principal and interest are known figures that can be planned for in a budget
Cons:
- Loan must be paid back within a fixed period of time, plus interest
- Relying too heavily on debt can leave a business vulnerable during hard times
- Qualifying for a loan is contingent on your credit score and financials
- Company assets can be held as collateral to the lender if you fail to repay the loan
- Owing too much debt can label you as “high risk” to potential investors
- Can limit the growth of your company
- Typically provides little to no guidance on best uses for the capital
Equity Financing
On the other hand, equity financing involves trading a portion of your business’s ownership to an individual, angel investor, venture capitalist or private equity firm in exchange for their capital. Although this finance option avoids the hassle of repayment or interest, there are strings attached – for instance, profits must be shared with the investor. It also requires devoting a significant amount of time and energy into finding and pitching the right investor for your business, industry and stage of growth.
Pros:
- Can tap into an investor’s network and experience, which may provide valuable connections and increase the credibility of your business
- Carries less risk because you’re not required to repay the capital
- Depending on the investor, certain equity providers can take a longer-term view with regard to ROI
- Don’t have to pay interest on raised capital
- More available cash on hand for expanding your business
Cons:
- Takes significant time and effort to find the right investor
- Requires giving up some ownership of your company and a percentage of the profits to the investor
- Will need to share the decision-making power with the investor
- Carries the risk of having to cash in your portion of the business if there are irreconcilable differences with the investor
Generally speaking, business owners often opt for a mix of both debt and equity financing to access capital for their company. The right ratio will depend heavily on your type of business, cash flow, profits and the amount of capital needed to grow and scale your business. However, it’s important to remember that, before business owners can drive growth and success to their company, they first need to focus on improving their cash flow cycle by getting their financial house in order.
Want to learn more about financing options for your small business?
Contact Evolution Capital Partners at (216) 593-0402.
