So let’s say you started or even want to start a business and need financing. Where do you get the capital need to start it? There are traditionally two ways to finance a business: Debt financing and equity financing (these days, there is also a third option, crowdfunding, but that is an article for a different day.)
Debt financing is what it sounds like – you get a loan and take on debt that will need to be paid back. Equity financing is when you get an infusion of cash from an investor in exchange for a share of the business. If you have ever seen the television show Shark Tank, that is equity financing; you sell a percentage of your business for the money.
One thing that both debt and equity financing have in common is that they make you a better businessperson. In order to get the loan, or induce that investor, you have to have a business plan that makes sense with numbers that are realistic. A good idea and a wild guess will not do. In both cases, lenders and investors want to see that you have a good understanding of your business.
The question then becomes, which option is better? The answer depends upon your business, situation and goals.
Here are the pros and cons to both debt and equity financing to help you decide which is right for your business.
Some benefits of debt financing include:
- No partners: While a bank or other lender will have a vested interest in your success, they do not become partners per se. If you like being the boss then debt financing is the way to go because you retain 100 percent ownership of your business.
- Builds credit: Getting a loan builds your credit, and having strong credit is always good for your business.
- Tax deductible: Interest on the debt is a business expense and tax deduction.
The downsides of debt financing are:
- Personal guarantee: Most business loans (but certainly not all) ask you as the entrepreneur to guarantee the loan personally. This then subverts your corporate shield as your personal assets (i.e., home, car, and investments) will be at risk if the business fails.
- You will be in debt: There is good debt and bad debt, and generally speaking, a loan to help you grow your business is good debt. However, if you can’t pay it back then it becomes bad debt.
For most entrepreneurs, the benefits of getting a loan usually far outweigh any negatives.
As mentioned, equity financing can seem like the perfect solution because you get the money and don’t have to pay it back. But of course, the analysis has to be deeper and more nuanced than that.
Aside from the cash infusion, another big benefit to getting an equity partner is that this will in fact be a partner – someone with a vested, financial interest in seeing you succeed. Angel investors therefore often help the entrepreneur in many other ways – with introductions, advice, feedback and so on.
But that same fact can also be a negative. As they say: The good news is that you will have a partner. The bad news is that you will have a partner. And investors and entrepreneurs don’t always see eye to eye, so there is always that too. Be prepared to spilt the pie (in many ways) if you seek equity investors.
Other factors on the positive side of the ledger include:
- More flexible pay back: Investors will want to see a return on their investment, yes, but that won’t be in the same, rigid timeframe that a loan requires. And if things do unfortunately go south, your personal assets are not at risk and you won’t be on the hook for a loan repayment.
- Intellectual capital: Angel investors are usually pretty sharp people who have been successful in business and want to stay in the game. Tapping that experience and expertise can be a real advantage.
Other negatives include:
- Sharing profits. Just as you will have to repay a loan, so too will you need to split the profits with your equity investor.
- Time consuming: it is usually a quicker process to get a loan than it is to find the right equity investor.
So, whether you decide that debt or equity is better for your business, it is good to know that you have options.
Have you recently financed your business using debt or equity financing? Share your story below.
About Steve Strauss
Steven D. Strauss is one of the world's leading experts on small business and is a lawyer, writer, and speaker. The senior small business columnist for USA Today, his Ask an Expert column is one of the most highly-syndicated business columns in the country. He is the best-selling author of 17 books, including his latest,The Small Business Bible, now out in a completely updated third edition. You can listen to his weekly podcast, Small Business Success, visit his new website TheSelfEmployed, and follow him on Twitter. ©Steven D. Strauss