Debt vs Equity Financing: What’s Best for Your Business?
As an entrepreneur looking to start up a new venture, one of the most pressing questions is how you’re going to finance the business. Usually, you’ll be choosing between debt and equity financing.
Understanding the difference between debt financing vs equity financing is key to your endeavor’s success. The basic debt fundraising definition generally refers to taking out a loan that has preset interest and timed payment intervals. Equity financing simply means giving out ownership of your company in exchange for cash flow.
Choosing debt vs equity financing can be an ordeal in itself. There are several factors that you need to consider. Before solidifying your choice between the many debt equity financing options, you need to analyze your business’s current stage, expendable income, capital structure, and the economy as a whole.
In this article, we’ll delve into the pros and cons of equity financing and help you determine which is right for your new venture.
Types of Debt Financing
Debt financing means that you’re collecting funds without giving up part of your company. In essence, it’s a loan that will be paid back with interest by a predetermined date. You may be asking, why is debt cheaper than equity? It may be hard to believe, but when raising debt, there are cases when this proves true. This usually happens when there’s a conflict between investors and the livelihood of the company is at stake.
The most common forms of debt financing include:
- Secured Lines of Credit: Obtained from financial institutions such as banks, secured lines of credit will give you access to cash with a reasonable interest rate.
- Term Loans: In a term loan, all capital needed for the venture is provided upfront by a bank or other lender. These loans have regular interval payments over a specified period.
- Credit Cards: You can find credit cards issued by banks or credit unions, and use them in a similar manner to personal credit cards.
- Merchant Cash Advance (MCA) Companies: The MCA line of credit is extended with the expectation that the company’s income will be used to pay it down. Many of these loans are structured to garnish a percentage of your daily revenue.
Pros & Cons of Debt Financing
Debt financing has empowered many small businesses to get their operations up and running. The major hurdle for these companies is qualifying for a loan at a low-interest rate. The most common ways you can qualify for a loan include having collateral, a properly structured business plan, a good credit score, and other supporting documents that lessen your perceived risk.
Pros of Debt Financing:
- You maintain ownership and subsequent profits over your company.
- You have a payment schedule, so you know when you’ll be done repaying.
- Interest rates are usually less than what you would need to pay out on equity investments.
- You can consider several different types of credit lines.
- There may be tax incentives, as the interest on the debt can be deducted.
Cons of Debt Financing:
- You have a fixed schedule of repayment regardless of the business’s success.
- Debt is calculated as an expense, which inhibits you from reinvesting revenue back into the business.
- The collateral presented when you sign a loan is at risk if you end up defaulting on the loan.
- Certain terms and conditions may be applied to the loan at the lender’s discretion.
Types of Equity Financing
When starting a business, equity financing has always been an option. However, it’s gained significant steam with the latest wave of entrepreneurs. It entails exchanging partial ownership of your company for money you can use to develop your business. While the traditional model, securing credit from a financial institution, is still the main source for most companies’ funding, seeking out venture capitalists and angel investors is the latest trend.
The three most common sources of equity financing include:
- Close Acquaintances: Turning to friends and family is a common way to gather funds in exchange for a small stake in a company.
- Angel Investors: Angel investors are usually individuals or small groups that are looking for companies in the seed stage. They’ll help launch a product in exchange for a significant portion of the company’s stock.
- Venture Capitalist: Individuals, commonly representing a firm looking for the next “big thing,” will risk large sums of money, reaching into the millions. They’ll help a company get off the ground in exchange for a negotiated portion of the business.
Pros & Cons of Equity Financing
Equity financing is frequently sought out by innovative startups with a high risk/high reward ratio. Venture capitalists might invest large sums of money into ten or more promising companies at a time, with only one developing a viable product.
Pros of Equity Financing:
- If your startup is only in the developmental stage and hasn’t gained any traction, equity financing may be a good way to create a minimum viable product (MVP).
- Nearly all of the monetary risk is on the investor, as you’re using equity in the company as collateral.
- Many investors can help create strategic advantages for your company, beyond serving as just a source of funding.
Cons of Equity Financing:
- The main disadvantage is that you’ll lose partial control over your company.
- Finding investors is an extremely challenging and arduous task.
- Most investors are not looking for long-term investments, with the average exit strategy falling within five to seven years.
Which Type of Financing is Right for You?
When it comes to choosing between debt vs equity financing and understanding how it will affect your company, you need to consider various aspects of your business. If you have a more traditional company and business model in mind, debt financing will be the simplest and most effective means of securing funding. However, if your company is immediately scalable or may disrupt an entire industry, then equity financing might be the best route for you.
Although you’re acutely aware of all your company’s needs, it’s not easy to decide between debt vs equity financing. If you need help making this tough decision, contact L3 Funding. We give small businesses the opportunity to begin their venture with better terms and specialize in providing merchant funding to small businesses throughout America. Contact us today or fill out an application form to get started.