Debt vs. Equity Financing - What's Best for a Small Business?
You are starting or expanding your small business and you need money. Which is better – getting a loan or getting investors? We'll explore debt financing (loans) vs. equity financing (investors), looking at how quickly you can get the money, how easy is the process, how much paperwork and legal help you will need, the cost, and the risk (to your company and the lender or investor).
How to Get Debt Financing
Debt financing, getting a loan for your business, is the most common type of financing for businesses, especially those who are just starting out.
Ease of Getting a Business Loan
While it's never easy to get money for a business startup, debt financing in the form of a business loan is usually straightforward and quick. The process begins with your preparing financial statements and a business plan to take to lenders. You can prepare these documents yourself, but it's a good idea to have a financial advisor take a look at the financial statements.
It can take months to get a business loan, and you may have to put up some of your own money (collateral), give a personal guarantee, or get a co-signer. Compared to finding investors, it's still easier to get a loan.
Control of the Business
When you have a loan, the lender has almost no amount of control over your business. They may ask for periodic statements to make sure your business looks financially sound, but you and other co-owners keep the control of business decisions.
Cost of Business Loans
The cost of debt financing comes in the form of interest payments. Because business loans are risky, the interest rate may be high. The rate depends on several factors: the age of the business, the credit rating of the business (or the owners, if it's a new business), and the type of lender. See this list of average business loan rates (2018) from ValuePenguin.
Risk of Business Loans
If your company can't pay its bills, the lender can call in the loan, and you may be required to pay it back. The risk to your business is the possibility that you won't be able to pay back the loan. This will affect your business credit rating and possibly cause you to go into bankruptcy.
How to Get Equity Funding
The way you get equity funding depends on the type of funding.
Types of Equity Funding
Private Investors. Your company can decide to get individual shareholders and keep the company private. The simplest type of small business investment is from private individuals, like friends and family. Businesses in technology or biotech fields may be able to get venture capital or angel investors.
You can incorporate your business and offer shares in stock to a select group of people without offering shares to the public (a public company). If you can persuade these people to invest in your business, you will need put together an agreement (prepared by an attorney) to make sure everyone knows what to expect.
Public Investors. When a company gets larger and wants to grow more, the typical way is to get people to buy shares of stock in the business. If the company wants to go public, it can arrange to have an initial public offering (IPO) of stock. This process takes much time and money because you will have to hire lots of people to help. Most small businesses don't go public until they are very large.
Control of the Business
Equity funding, whether it is private or public, involves giving up control over the operations, because the investors want to be sure the company succeeds. You will have to put shareholders on your corporate board of directors and they will be looking over your shoulder to make sure their investments are doing well.
Ease of Getting Equity Funding
It's fairly easy to get private investors, especially if they are friends and family. It's much more difficult to get venture capitalists or other investors to pay attention and to put together a deal. A private stock offering requires financial and tax professionals and probably years to put in place.
Risk of Equity Funding
Investing in a business is risky. The investors must understand that if the company closes or goes bankrupt, they will probably not get their investment back. Even family members may become disenchanted if they don't see a return within a few years.
The Bottom Line on Debt vs Equity
When you need money to finance your business startup or expansion, you have to figure there will be a trade-off between the factors:
It's easier to get a loan, and you keep control of the business, but the cost can be high interest rates and the chance that the lender will foreclose.
It's more difficult to get investors, and they will demand control of the business. Investors take a large risk because they could lose all their money; for that risk, they demand high returns.
If you are just starting a business, a business loan is your best bet for raising money.