Small Business Finance – Debt or Equity?
Debt financing is the use of borrowed money to finance a business. This type of financing is appropriate when money is needed to finance a specific asset and you are confident that the cash flow in the business will enable you to service the loan.
Generally, it is advisable to match the term of a debt to the estimated life of the asset being funded.
Equity investors buy part of your business by providing some of the investment capital your business needs. Given that they are going to own a share of your business, equity investors have an interest in the business’s long-term success and potential earnings.
Although the original owners can find themselves with a smaller proportion, issuing equity could also substantially improve their wealth.
Choosing Between Debt and Equity Financing
There are many components to running a business successfully. Financing is believed to be the main one. Until you can finance your venture, you are unable to begin and continue operations. There are generally two main financing options available, other than putting only your own money into the venture. You may choose debt financing or equity financing.
Debt financing involves borrowing money for running a business. Regardless of whether your venture is successful or not, you will have to repay the borrowed sum plus interest. The most common form of debt financing is the bank loan, even though there are other options as well.
Equity financing involves selling a share of your company. Basically, you get an investor to put money into your venture and, in turn, the investor gets partial control of the company. The person or company investing in your business will have a share of the profits as well. Similarly, if your company fails, the investor will lose their money.
The logical question to ask now is which option is better. Some people who have little experience in running a business will say that equity financing has many more benefits and virtually no drawbacks when compared to debt financing. However, this is not exactly the case.
Getting a business loan certainly hides a lot of risks. You may not be able to repay it if your company fails. It is also possible for you to be on the losing side if you have to pay more to the bank than you actually make from your venture.
In addition, you will most likely have to take out a secured loan which will put major collateral at risk. On the other hand, by using debt financing, you will be the sole owner of the capital and take all managerial decisions without having to share profits or make compromises.
Indeed, these are the major drawbacks of getting equity financing. An investor will have a say on all questions regarding the company, especially if you give them a considerably large share. In addition, if your venture becomes a success, you will have to split virtually every penny of profit with the investor. Still, you will get the investment you need in the beginning without assuming the risk of having to repay the borrowed sum plus interest.
Overall, it really is your decision which option to choose. You can choose a combination of both. Just base your final decision on the investment you need for running a business.