As entrepreneurs think about going into business, their biggest concern is money. How will they afford the start up costs? Or for those wanting to expand their business, where will with necessary funds come from? They begin to look at going into debt or using available equity. And of course, the added decision of financing.
The two main financing options are debt and equity. While debt financing in simple terms means borrowing funds. Getting a loan for a fixed period while paying interest. Equity financing is raising money by selling a share of the business to individuals or institutional investors. Selling equity means sharing the ownership in your business depending. The amount you are sharing depends on the amount of money you need. As with any financial decision, seeking the support of a professional or expert in your industry is always step number one. But, here is a brief introduction to the advantages and disadvantages of both debt and equity financing.
One of the greatest advantages to debt financing is the tax deduction. After meeting with your accountant or CPA to confirm; the interest on your loan may be a tax deduction. Additionally, your business stays completely in your control. The lender has no claim over the profits or ownership. Your liability is limited to repaying the borrowed amount with interest on time and in full.
As always, there is two sides to every situation. Too much debt can spoil your business’s credit rating. The balancing act is something your accountant can help you with. It is understood that assets of your business will need to be used as collateral in exchange for your loan to be approved. If you default on payment, then these assets can be seized by the lender. Additionally, with debt financing, the lenders can set very hard terms and conditions for obtaining loans. Your business may also need to have sufficient cash flow in order to meet your repayment obligations.
The key advantage of equity financing is that you can use the available cash flow to grow and expand your business. What’s more, you do not have to repay your investors even if your company declares bankruptcy, neither do you have to pledge the company’s assets as collateral to obtain the equity finance. Finally, the company’s balance sheet appears healthier with equity finance than it does with debt funds. Remember, with equity financing, you need to have an accountant review your finances, business plan and sales projections.
Flipping the card with equity financing, the ownership will more than likely have to be shared. Also, in most equity financing instances, the investors will ask to serve in a managerial role to oversee that their investment is heading in the right direction. As a result, decision making often gets affected if you and your investors are not sharing the same vision for the growth of the company.
It’s obvious both debt and equity financing options come with their own sets of pros and cons. Before making your decision, it is important you study your business’s needs carefully. Deciding which disadvantages you can live with and which advantages you want to make use of the most. At the end of the day, financing is a strategic business decision you can’t afford to take lightly. Seeking the support of other professionals to review and assess all your options is one of the first critical steps you will need to take.