Funding Your Business: Debt Financing vs. Equity Investments

It takes money to make money. You’ve probably heard that old adage more times than you can count, and as a business owner, you can attest to its veracity. While many entrepreneurs have self-financed their companies, there are many others who have had to secure outside funding to start, grow, or maintain their businesses.

When the need arises for raising capital, entrepreneurs are faced with two alternatives: Securing a loan and bringing on investors. Both options have their pros and cons, and both have implications on your company’s valuation. But before you sign-on the dotted line, let’s take a look at some of the benefits and drawbacks for each option.

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Debt Financing

Whether you open a line of credit, rely on a term loan, or use a small business credit card, debt financing means you’re borrowing money. Entrepreneur and Shark Tank star Mark Cuban doesn’t mince words about his opinions on this topic. He once told Trish Regan on Bloomberg Television’s “Street Smart”: “There’s so many uncertainties involved in starting a business, yet the one certainty you’ll have to have is paying back your loan.”

While Cuban raises a valid point, the reality is that only a small fraction of start-ups receive venture capital funding. The majority of businesses raise their capital through loans and lines of credit. There are several advantages to doing so, too.

  • You maintain control of your business. Another point Cuban made in support of his opinion on loans was that “The bank doesn’t care about your business.” The implication is that the bank just wants you to make your loan payments. It doesn’t care what your cash flow looks like. It doesn’t care if you’re breaking even yet or not. It just wants to be repaid. That’s true. On the other hand, it also means that the bank also doesn’t care about how you manage your company. Business decisions remain yours, and once you pay off your loan, the relationship is over.
  • Loans are accessible. Attracting outside investors can be hard. Securing a loan is a lot easier. In fact, nearly 90% of small businesses list some form of debt financing as a source of funding. Businesses also have the option of pursuing SBA-guaranteed loans.
  • Paying back your loan improves your business credit score. A healthy business credit score is good for more than just securing additional credit. It also speaks volumes to your vendors. Additionally, a strong credit score won’t hurt your overall business valuation, whereas a less healthy one might.

Be aware, however, that debt financing isn’t all sunshine and roses. You will be required to make fixed payments on specific dates. As noted above, the bank doesn’t care about your cash flow or your income. It just wants its money back on the schedule you’ve agreed to. Failing to do so could cause you to lose whatever collateral you put up against the loan. In addition, taking on too much debt could also lower your business valuation, making your company less attractive to equity investors and organizations that may be interested in acquiring your business.

Equity Financing

Another option is to pursue equity investments from outside investors. In this scenario, investors give you the money you need in exchange for a piece of your business. Money could come from angel investors, venture capitalist, investment firms, and even friends and family.

Benefits of equity financing include:

  • There are no loan payments to make. Equity financing isn’t a loan. Your investors won’t be looking for regular fixed payments to repay the money infused into your business.
  • There’s no additional financial burden added to your company. With no loan to repay, there’s also no direct impact on your cash flow, which means you can continue to direct your revenue to building your business vs. repaying your loans.
  • You’ve gained a mentor. Your equity investors make money by sharing in your business’s success. They can be a valuable resource as mentors with a vested interest in your business growth.

The downside, however, is that someone else (or multiple people/organizations) own a piece of your business and may want a say in how you run it. This includes, by the way, the decision of whether or not you sell your business and for how much you sell it for. The only way to dissolve the relationship with an equity investor is to buy out their shares. Doing so may cost you more than their original investment, and can be more than you would have paid for a loan with interest.

Of course, the decision to secure funding and what type of funding requires a lot of research and consulting with qualified professionals. At Peek Advisory Group, we work with business owners to help them understand the benefits and risks associated with financing, and find the solution that is best for them in the long-run.