Debt vs. Equity: What Small Business Owners Need to Know
Posted by Guest Author on June 5, 2013 in Business Financing, Business Management [ 0 Comments ]
A source of cash is critical to keeping the lights on and the payroll running, but choosing exactly how to secure a steady cash flow can be a difficult decision.
Most small businesses face two options: debt financing or equity financing.
Here’s what entrepreneurs need to know to help them make the decision that’s right for them.
Debt financing is exactly what it sounds like: business owners take on debt to finance their companies by taking out loans from friends, family, banks, or other lending agencies. Whether they’re short-term or long-term, nearly all loans require the payment of interest. As with most financial decisions, the choice of debt financing comes with positives and negatives.
- The positives: Choosing to take out a loan allows you to determine how much money you’ll need and how much time you’ll need to pay it off. Unlike equity financing, which requires you to give up a portion of the ownership of your company to an outside investor, debt financing allows you to maintain full control of your company.
- The negatives: Making monthly loan payments can be difficult for any borrower, and small businesses often struggle even more, as most early-stage companies tend to have limited sources of income. Moreover, the more small business entrepreneurs spend on paying off their debts and on debt interest, the less they’re available to invest in growing their companies, which can lead to business stagnation.
Given that securing equity financing often requires greater degrees of business development in order to attract investors, debt financing can be an excellent option for smaller-scale companies that are just starting up. When looking to secure small business loans, the US Small Business Administration is a great place to turn, as it works to promote small business by offering favorable loan packages to small business entrepreneurs.
Equity financing involves offering a percentage of the ownership of your company to investors in exchange for capital. Venture capital firms and independent ‘angel’ investors often look to invest in startup companies that they feel have the potential to turn significant profits. In seeking equity in companies by offering them capital, such investors take on the risk that you might not be able to repay the loan in the hope that your company will succeed and they’ll eventually make money from their partial ownership of your company.
- Equity financing can be very useful in that it allows entrepreneurs to focus on growing their companies rather than worrying about being about to make loan payments. Without the stress of a heavy debt burden, entrepreneurs are free to develop their products or services, which in turn can attract the interest of even more investors.
The main drawback of equity financing is that in offering investors a degree of ownership of your company, you also give them a say in business decisions regarding your company. When dealing with experienced investors, this can be an advantage, as they can offer critical mentorship in the early stages of your company. After all, it’s also in their best interest that your company succeeds. However, losing total control of your business and the decisions that affect it can be a very frustrating experience for many entrepreneurs.
When both debt and equity financing offer significant advantages and disadvantages, what’s an entrepreneur in need of capital to do? Choose both. For small businesses, the ideal debt-to-equity ratio is between 0.5 and 1, and certainly no more than 2. And how do you achieve this ratio? Diversify your sources of financing. As a fledging startup, chances are that you’ll only have access to loans from friends, family, and banks. Take on those debts, as they’ll be necessary for your future growth. But as your company develops, start to consider offering equity to investors as means for future capital.
Bio: Liz Jacob is a writer and editor living in New York. She is a writer for Biz2Credit Business Loans, the #1 online credit resource for small business loans , business loans for women, equipment financing, working capital and other funding options. Biz2Credit has secured $800 million in funding for small business owners in the U.S. since 2007. Follow @biz2credit on Twitter and Facebook for company and industry updates.