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Understanding Debt vs Equity Financing

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Understanding Debt vs Equity Financing

Updated: March 27th, 2020

Understanding Debt vs Equity Financing

Debt vs Equity Financing

Outside financing for small businesses falls into two categories:

Debt financing involves borrowing a fixed sum from a lender, which is then paid back with interest.

Equity financing is the sale of a percentage of the business to an investor, in exchange for capital.

Before you seek capital to grow your business, you need to know where to find debt vs equity financing, which of the two types you qualify for, and how to weigh the pros and cons of each. Watch the following video and read through the guide to learn what the best options are for your business.

Types of debt financing

Debt financing comes in many forms from many types of organizations, they include:

  • Secured lines of credit from banks or other financial institutions: Though harder to get, this type of financing has low interest rates, and lets you draw down only as much cash as you need, in any given period.
  • Term loans from banks or alternative lenders like Bond Street: These provide the full amount of capital upfront, and require regular payments over a fixed amount of time. (Learn more about term loans here)
  • Credit cards from banks, credit unions, savings and loans, and other financial institutions: You borrow money that must be paid back with interest after a grace period.
  • Invoice or receivables financing from financial companies: When you need cash on hand, this form of financing fronts capital at a discount, for income you would receive later.
  • Merchant cash advance from MCA companies: This loan product is tailored to businesses which receive the bulk of their revenue via credit cards. The lender takes a fixed percentage of your daily credit card receipts. (MCA’s can be a bit confusing, so be sure to check out the following guide if you’re considering an MCA as an option for your business.)

Types of equity financing

Equity financing typically comes from three sources:

  • Friends and family (or other small investors): These private investors put a relatively small amount of money into your business in exchange for relatively small pieces of the pie.
  • Angel investors: Also generally private individuals or associations, these investors typically put 10s to 100s of thousands of dollars into your company and are sometimes looking for a large ownership percentage.
  • Venture capital firms: These firms publicly invest millions of dollars into very promising startups.

Is equity financing right for your business?

Equity financing is most appropriate for high-risk technology and innovation startups, with the potential to generate a huge return on investment, as well as businesses in very cyclical industries that do not have a steady cash flow. Venture capitalists  have demanding criteria; they typically seek to invest in companies with ambitious plans, like market domination or global reach. Investors of every type will carefully study your business plan for a strong background and management team, a demonstrated need for your product or service, a clearly defined pricing and sales strategy, preparation for competition, and realistic financial projections.

Pros of equity financing:

  • For new businesses with no revenue or those which are yet to attain profitability, equity financing can be your best if not only option.
  • Investors take on almost all the risk; they receive their returns only if the business succeeds
  • No percentage of your revenues will be diverted to pay loans.

Cons of equity financing:

  • You  give up a  percentage of your business.
  • Investors may have control over key decisions and influence the culture of the company.
  • Landing investment can be a full-time effort, and reporting to investors regularly can take precious man-hours.
  • Investors or “equity partners” usually do not expect a return on their investment for 3-5 years, but they often exit after 5-7 years.

Is debt financing right for your business?

Many types of small businesses benefit from the advantages of debt financing, particularly, those in traditional sectors like retail, hospitality and manufacturing. To qualify for loans and secured lines of credit, companies need to show some operating history and profitability. Before you seek debt financing, you need to have good reason to believe that you’ll have enough revenue in the future to pay off the debt. Lenders typically require collateral or a personal guarantee, a business plan, good credit scores, copies of your tax returns, financial statements, and an application.

Pros of debt financing:

  • Can be used by almost any kind and size of business.
  • You retain ownership of your business, which means you will not have to share profits long-term.
  • You know when you need to repay.
  • There are a range of options (different kinds of loans, credit cards, lines of credit, etc.).
  • Interest on the debt can be deducted from the firm’s tax return.
  • Interest rates on loans are usually lower than the return on equity investments.

Cons of debt financing:

  • Requires repayment of both principal and interest whether business is good or bad.
  • Debt is an expense and expenses prevent you from reinvesting your revenue in the business.
  • There’s always a risk. Defaulting will cost you the assets (or personal guarantee) you pledged as collateral.
  • Lenders may restrict what you use the money for or whether you can look for more financing elsewhere.
  • With some analysis and information, you should be able to discern whether debt vs equity funding will most benefit your business.

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