Equity vs. Debt Financing: Pros and Cons for Small Businesses
The recipe for the growth of any business includes three ingredients: manpower, intelligence, and funds. The first two are essential but also useless if you don’t have the third one. A deficiency of cash can cripple any firm, especially in its initial phase. Whenever a shortage is a possibility, business owners need to come up with a viable financing option.
The two most common options business owners turn to, are equity and debt financing. Which of the two is a better choice is a dilemma many entrepreneurs face. To make this turmoil a bit easier for you, we present the ultimate battle between equity and debt financing. Let’s see which competitor will take the throne, at least when it comes to your business.
What is Equity Financing?
Equity financing means searching for investors and negotiating the purchase of a part of your business. To translate it into a more understandable statement: it is similar to selling the shares of your firm to stockholders who will take a share of the profit in the future.
This means that you, as the primary owner, are not obliged to pay back the amount of borrowed money with interest, but that you give a certain percentage of your company in return for funding. You are free from paying regular installments, but your company doesn’t belong exclusively to you anymore.
There are different ways to gain a fund from equity financings. You can sell shares in your business to investors. Equity financing can be a gain from a private or an “angel” investor, but it can also be acquired from a friend or family member. Also, there are professional institutes that work as platform firm selling and buying stocks such as venture capital.
Pros of Equity Financing for Small Business
The most notable benefit of equity financing is that there are no major risks involved. In fact, there is almost no risk at all. Since you don’t have to pay the money back and none of your assets are in danger of being confiscated, this is considered a risk-free gain.
Furthermore, equity investment gives you a chance to grow a network of opportunities.
In the worst-case scenario, you are not liable to pay any money to the investor, if your business tanks.
Cons of Equity Financing for Small Business
The first disadvantage of equity financing for a small business is very obvious – you will have less control over the business operations and management because you will be sharing the ownership with a number of investors. As a result, you will have to consult with them before making any major decisions.
The second problem comes in the initial phase of equity financing, and it includes the search for a willing investor. This task requires a lot of time and effort, and it is even more complicated if you are just starting your small business and do not have a reputation as a business owner or a company.
What is Debt Financing?
Debt financing is taking a loan from a lender outside of your business. It can be a bank, a private lender, or another option. When applying for a small business loan from any institution, you are agreeing to pay back the borrowed money in a predetermined number of installments, and with interest.
Since entrepreneurs are among the most common loan applicants, there are many loan types designed specifically for businesses. The Small Business Administration (SBA) programs, for example, are loans crafted solely for the purpose of helping small businesses acquire the funds they need.
There are, of course, different terms you need to comply with to be eligible for the application, but the lender will never take a share of your business.
Pros of Debt Financing for Small Businesses
Debt financing gives you full control over the funds you’ve received and no one can debate that with you. The influence of the loan on your business lasts only until you repay what you owe. After the repayment is over, you are the only proprietor of your company. And since there are fixed installments to pay in a certain period of time, there are no insecurities involved. You can also get some perks for paying on time or for choosing a long-term loan.
Cons of Debt Financing for Small Businesses
Not everything is as peachy as it seems in the land of debt financing. Unfortunately, this type of acquiring funds comes with a high risk, when it comes to legal actions and confiscations which can be made against you if you fail to pay back what you owe in due time. The loan is often secured by the assets of your company which means they can be sold by the lender if you cover the installment on time.
Regardless of all the benefits, business loans are a burden, and they are not an attractive feature to have, particularly if you are in search of an investor. Debt financing also leaves your firm vulnerable to damage.
So, What to Choose?
It all comes down to assessing your circumstances. If, for example, you need money urgently, for a short term, and the sum is not significant, it is better to opt for debt financing. Equity financing is recommended in situations where you need a large sum of money or an experienced partner/advisor to obtain substantial growth.
We hope you enjoyed this promoted piece as much as we did!
