Small Business Financing: Debt or Equity? – Natural Self Esteem

Small businesses often need money. This is especially true for companies in the early stages of development. There are two basic types of financing available to small businesses: debt financing and equity financing. What’s best for you as a small business owner?

The central theses

  • Start-up small businesses can use equity financing or debt financing to raise money when they’re short on cash.
  • A bank loan is a form of debt financing used by small business owners.
  • Equity financing means that stakeholders own part of the company.
  • Getting a small business up and running often involves taking on debt.
  • Some business owners use personal funds or take on debt in the early stages of starting their business.

debt financing

Buying a home, buying a car, or using a credit card are all forms of debt financing. You take out a loan from a person or company and promise to pay it back with interest. Debt financing for your business works in a similar way.

As an entrepreneur, you can apply for a business loan from a bank, or you can get a personal loan from friends, family, or other lenders, all of whom you have to pay back. Even if family members lend you money for your business, they must calculate the IRS minimum interest rate to avoid the gift tax.

The benefits of debt financing are numerous. First, the lender has no control over your business. Once you repay the loan, your relationship with the financier ends. Next, the interest you pay is tax deductible. After all, it’s easy to forecast spending because loan payments don’t fluctuate.
The downside of debt financing is authentic to anyone in debt. Debt is a bet on your future ability to repay the loan. What if your business is going through hard times or the economy is going through another meltdown? What if your business isn’t growing as fast or as well as you expected? Debt is an expense, and you have to pay expenses regularly. This could slow down your company’s ability to grow.

Although you may be an LLC or other business entity that provides some segregation between the company and personal funds, the lender may still require you to use your family’s financial assets to guarantee the loan.

equity financing

The public does not understand equity financing and debt financing because equity financing involves investors. You might offer shares in your company to family, friends, and other small investors, but equity financing often involves venture capitalists or angel investors. The popular ABC series Shark Tank features entrepreneurs pitching their business idea to a group of investors to secure equity funding.

The main advantage of equity financing is that the investor bears all the risks. If your business fails, you don’t have to pay the money back. You also have more cash on hand as there are no loan payments involved. Finally, investors have a long-term perspective and understand that it takes time for a company to grow.

The downside is big. To get the funding, you must give the investor a percentage of your business. You must share your profits and consult with your new partners when making decisions affecting the business. The only way to remove investors is to buy them out, but that will likely be more expensive than the money they originally gave you.

If you think debt financing is right for you, the US Small Business Administration works with select banks to offer a guaranteed loan program that makes it easier for small businesses to secure financing. Visit the SBA website to learn more about these programs.

Which financing method should I choose?

Traditional equity funding is difficult to secure, especially for small early-stage startups. Often you have no choice. Venture capitalists typically look for companies with a global reach. Angel investors who fund on a smaller scale often want to invest around $600,000 in new startups, but if you’re looking for them, there are angel investors who also invest less.

If your business is a startup serving a local market and doesn’t need large-scale financing, debt financing is probably your best, and perhaps only, option. Better known startups often combine debt and equity financing to reduce the disadvantages of both types.

What is Debt Financing?

When you borrow money to buy a car, a home, or even a trip, these are forms of debt financing. If you, as a company, take out a personal or bank loan to finance your business, this is also a form of debt financing. With debt financing, you not only pay back the loan amount, but also interest on the money.

What is Equity Financing?

When you finance your startup expenses with equity financing, you are borrowing money against existing or future equity. Investors provide equity financing by essentially buying stock in your company.

What is better for my business, equity or debt financing?

The benefits of using equity or debt financing to fund your startup expenses depend on how much money you need and the size of your business. If you think you only need a few thousand dollars to start, it may be easier and cheaper to borrow money from a friend or family member, or even take out a small bank loan. If your business needs hundreds of thousands of dollars to get started, equity financing may be a better route.

The final result

The type of funding you are looking for mainly depends on your startup. If you’re just starting out and can start with little capital, consider a family, friends, or bank loan. As you grow and reach a larger market, equity financing may become a more viable option if you are willing to give up part of your business.

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