Debt and Equity Financing: Options for Your Small Business

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Whether you're preparing to launch a startup or to grow your business, one thing is for certain: You’re going to need money. Debt and equity financing are two different strategies: Taking on debt means borrowing money for your business, whereas gaining equity entails injecting your own or other stakeholders’ cash into your company.

Debt Financing

Debt financing is when you get a loan, from a bank, a commercial finance company, or private entity.

These are structured financial arrangements that will require you to pay interest and meet a schedule of repayment terms. There are stipulated penalties if you do not meet these requirements.

This could be a good option so long as you expect to have sufficient cash flow to pay back the loans, plus interest. The major benefit for debt financing, unlike with equity financing, you'll retain full ownership of your business. The interest on business loans is also tax-deductible, and you’ll build your credit.

Bank loans for small businesses are not as easy to obtain as they once were. Your business must have longevity, an excellent track record, and unblemished credit. You may be asked to sign the loan as a personal guarantor.

Loans may be unsecured or secured. Unsecured loans are not tied to any property or assets. Unsecured loans are hard to come by.

Secured loans are back by property or other assets.

It might be business machinery, or your house, tangible holdings that the bank could seize if you default on the loan.

Commercial finance companies also lend money and are willing to fund riskier ventures that don't have solid financials. But this type of funding usually comes with a high interest rate.

Equity Financing

Small business owners often opt for equity financing because they have concerns about either qualifying for a loan or having to channel too much of their profits into repaying the loan. Investors and partners can provide equity financing, and they generally expect to profit from their investments. No debt payments means more cash on hand. Moreover, if no profit materializes, you aren’t obligated to pay back equity contributions.

The major drawback of equity financing is that you are no longer the full owner of your business . Financial contributors will expect some share. The more shares that are in the hands of contributors, the less control you have over your business and its destiny.  

There are also so-called angel investors: wealthy individuals or networks that are willing to fund small businesses in return for equity. Angels are an important source of seed and start-up capital for businesses, investing $24.6 billion in businesses in 2015, according to the Center for Venture Research at the University of New Hampshire.  Crowdfunding is a networked form of angel investing

Venture capital firms, on the other hand, provide equity for businesses and expect high returns on their investments, usually within three to five years.

They generally fund companies with significant growth potential, not small businesses.

Most businesses have a mix of debt and equity financing. Too little equity could prevent you from securing or repaying loans, while carrying little or no debt could indicate that you are too risk-averse, and that your business might not grow as a result. Seek advice from your accountant, lawyer, and business advisors to determine if you need an infusion of cash, how much, and what kind(s) of financing should be considered.