There are several elements businesses have in common whether they are large or small. One of these elements is the need for capital, the amount and type of financial resources a business needs to execute its business plan. Capital falls into two different categories: debt capital and equity capital. Many businesses use both in different proportions, at different times, and for different reasons.
- Debt financing is borrowing money from a lender in exchange for interest payments.
- Equity financing is borrowing money from a lender in exchange for equity.
- High-growth businesses may want to go public in the future and they may seek venture capital.
- Smaller businesses may prefer debt financing since they don’t lose control of their firm and because debt financing is cheaper than equity financing.
- The best capital structure for a small business is where its cost of financing or the weighted average cost of capital is minimized.
How Does Debt Financing Work?
When you use debt financing, you are using borrowed money to grow and sustain your business. Equity financing, on the other hand, is allowing outside investors to have a portion of the ownership interest in your firm. Each form of financing has different characteristics.
Small businesses usually open by using funds from the owner. The owner may use their personal savings for the startup. Alternatively, the owner may leverage what is usually their largest asset to start the business, which would be their home. They could:
- Refinance and take money out of their home equity
- Obtain a home equity loan or home equity line of credit (HELOC)
- Obtain loans from family and friends
These are all forms of debt financing since the owner has to pay them back with interest.
Except for these personal sources of funds, debt financing may be hard to obtain in the early stages of a small business since the business has no financial track record.
When you borrow money to operate your business, you agree to repay the principal plus interest over a certain term at a particular interest rate.
Small business bank loans may be hard to obtain until the business has been open for one year or more. The business would have to produce collateral, which most businesses do not readily have at first.
Other forms of business loans do exist. Business owners can borrow money using their accounts receivable, inventory, or equipment as collateral. When a business uses accounts payable to pay for supplies, for example, they are using trade credit, which is a form of debt financing.
Businesses can also apply for Small Business Administration (SBA) loans, microloans, peer-to-peer loans, and more. Some may have more favorable terms than others, but debt financing is always basically the same. The business owner borrows money and makes a promise to repay it with interest in the future.
How Does Equity Financing Work?
The key characteristic of equity financing is that investors supply funding to your business and in return, you give up a piece of your ownership. If your business is a small, local business, you may not want to give up a piece of ownership in your business to a large venture capital firm, for example.
Venture capital firms provide funding to high-growth startup businesses, often in the technology industry or that have new and different ideas or business models. They expect the startup business to go public after some time, and help with funding.
There may be times when a small business that is not technology-oriented would welcome an angel investor. If the owner needs particular expertise and an angel investor has that expertise, the owner may be willing to swap a piece of the business for the expertise, in what is called sweat equity or an in-kind contribution.
Equity financing is considerably more expensive than debt financing. There are transaction costs, often called “flotation” costs, associated with raising money through equity financing. These costs are substantial, especially for small issues of equity. The cost of equity financing through venture capitalists is a portion of the control of the firm.
Debt vs. Equity Financing
|Debt Financing||Equity Financing|
|Cost of Financing||Interest Payments||Ownership Interest|
|Collateral||Yes, in some cases||No|
|Repayment||Principal plus interest||Possibility of high rate of return|
|Cost of Capital||Low||High|
|Risk||Bankruptcy||Investor expectations of high returns|
|Who Provides the Money||Financial institutions, family and friends, SBA, peers, business credit cards||Venture capitalists, angel investors, equity crowdfunding|
Which Financing Is Right for Your Small Business?
It depends on several factors. If you have a promising idea for a different kind of business model, especially in the technology area, you may think your new business is a good candidate to go public one day. If this describes you and your business, you may want to consider equity financing through a venture capital firm. However, you must have an introduction to a venture capital firm before you are even considered.
However, if your network includes those connections and you want to do the necessary work to make your firm attractive to a venture capitalist, it might be a possibility. The same is true if you want to draw in an angel investor.
For most small businesses, venture capital is not a good fit since venture capitalists are interested in taking businesses public and getting a high rate of return on their investment.
If you don’t want to involve venture capital or an angel investor, the best fit for you may be debt financing through a bank loan or an SBA loan.
You may have to complete at least three years of projected cash flows and develop a well-thought-out business plan for the SBA or to bankers. That may be a lot of work on the front end, but your reward will be bank financing. Debt financing is cheaper than equity financing and you will not lose ownership interest in your business.
Mixing Debt Financing and Equity Financing
Is there a best of both worlds option when it comes to using debt or equity financing for your small business? The answer is yes. Many businesses choose to use debt financing and equity financing, hopefully minimizing the business’s overall cost of capital. The cost of capital for a business is the weighted average of the costs of the different sources of capital. The optimal mix of debt and equity financing is the point at which the weighted average cost of capital (WACC) is minimized. That mix is called the firm’s capital structure.