When it comes to financing, it couldn’t seem more complicated. There’s this kind of financing for that, or that kind of financing for this. It all starts to sound the same. Here’s an easy guide to help you differentiate between two of the most prominent methods of financing: debt financing and equity financing. We’ll also cover their advantages and disadvantages so you can make the best decision for yourself or for your and your company by assessing where you stand to lose and where you stand to gain.
Keep in mind that both of these methods do have attractive features to them, but the attractiveness might be more than your company can handle. Be realistic when choosing.
Debt financing is money borrowed in the form of a loan from a bank, private lender, financial institution, or commercial finance company to fund your business. It is money that you are borrowing with the intention of repaying it back in full including any accrued interest fees. It is a loan, it is not money that belongs to you.
The Advantages of Debt Financing
- You maintain full ownership of your company in the process of acquiring capital
- Your dealings with the bank, private lender, financial institution, or commercial finance company end the moment you pay back the money you owe
- Most interest rates of debt financed loans are tax deductible, an attractive feature
- Debt financed loans can be both long term and short term loans
- The principal sum and the interest rate are figures you can factor very easily into a budget (only if you do not take on a variable interest rate on the loan)
The Disadvantages of Debt Financing
- Borrowed capital must be paid back within an agreed upon, fixed amount of time. When that time is up, you better have your money!
- If you become too reliant on debt through this method, it will cause cash flow issues and will create problems with your ability to repay the loan
- Too much debt in a company can put you into a “high risk” bracket, which makes you unattractive to most investors, especially those that are staunchly risk-averse. This could limit other investment opportunities in the future
- Your business may be in a vulnerable financial position if or when sales figures begin to dip
- Having a high debt load can create difficulty when it comes to growth because of the constant need to be paying loans back
- Business assets are often held as collateral to the lender as a guarantee that the loans will be repaid, therefore these assets can be seized if necessary
Equity financing is accepting capital from investors or partners in exchange for a stake of ownership in the business. This is money you are raising by selling off small portions of ownership to your company. While you may be giving up percentages of your company, the money you earn from equity financing is yours and you don’t need to worry about increasing your company’s debt load or having to pay it off in the future.
The Advantages of Equity Financing
- If you can’t afford to take on new debt, this is a great choice because it’s capital that you do not need to pay back
- You share all risks, responsibilities, and liabilities with your investors
- By taking on new investors, you take on that investor’s network. This could add remarkable credibility to your company and also create new opportunities you would not have had otherwise
- Investors are often long-term thinkers and will not anticipate returns on their investments immediately
- You can keep profits to yourself! You don’t have to worry about putting them towards loan payments
- You will have more liquid capital to expand your business with
- You have no obligation to return the investment if the business flounders or fails completely
The Disadvantages of Equity Financing
- Investors may expect returns that are higher than the rate would have been for you if you had borrowed money from the bank
- Investors often expect some kind of ownership in the company in exchange for their money. This means a percentage of your profits belong to them. You would be giving up some of your control as a business owner to make this work
- Investors will have a seat at the table, meaning when you have a decision to make, they will need to be consulted to make sure they are on board with whatever course of action you are planning to take
- In the off case that you cannot and do not get along with your investors, it is possible that you will have to surrender your portion of the business in order to allow your investors to run the company themselves
- It is tedious and time consuming to find an investor that you trust to bring on in your company
Ultimately, companies tend not to rely on one method over another, though some do. It is commonplace today for companies to use a combination of debt financing and equity financing to generate capital for their businesses. This means that they won’t be selling off huge portions of their company to investors or financiers, nor will you be crippling yourself inadvertently by taking on too much debt.
When determining what method is right for you, it is important to assess your financial situation from all angles. Make notes on your short term goals as well as your long term goals. These goals can vary anywhere to making new hires, buying new equipment, branching out, expanding a marketing strategy, buying new assets, etc. The list is endless when it comes to what you want to do for yourself and for your company. Make projections of where you would like to be financially but where you actually are based on hard numbers in your books. It’s also crucial for you as a business owner to be realistic with what you can and cannot handle when it comes to debt. That is a huge factor in determining what kind of financing is right for you.
What kind of business you are also affects which method is right for you. Smaller, start up companies will have more difficulties acquiring equity financing because most investors aren’t chomping at the bit to invest with small, unknown companies that haven’t been around long enough to establish a reputation. If you are, however, a company that has been in the industry for a while and have created a name for yourself, you will have no trouble using either method, especially equity financing. If you have a favorable track record, investors will be waiting in line to get in on the action! But, just because they are eager to invest, doesn’t mean they’re the right investors. You must be very selective and very thorough when it comes to choosing who you invite to sit at your table. You want to make sure they’re coming with a full plate to offer you and your business, not a doggy bag empty ready to do nothing but take, take, take.
Whatever option you choose, be aware of what you’re getting into and make sure you’re keeping your company’s best interests in mind! You want to succeed, but you want to succeed in the best, most responsible and satisfying way possible. It makes all the difference in the world.