The pros and cons of debt and equity financing
It’s finally time: after months, if not years, of bringing a startup idea to life, you are ready to turn your dream into reality. Well, you’re mentally ready, at least. Before you can really move forward, you have to find the thousands – sometimes hundreds of thousands – of dollars that are often needed to launch a startup. Among the options available to raise the necessary start-up capital are debt financing and equity financing. While you can continue both, you need to understand their differences, disadvantages, and advantages before you start.
Debt or equity financing
The main difference between debt financing and equity financing is whether you are paying to get them. Debt financing requires you to repay the money you receive, with interest, over an extended period of time. Equity financing does not require any repayment, as you cede part of your business to the investor in exchange for the capital.
Some experts argue that while debt financing requires you to pay off loans and interest, equity financing can be expensive for your business. more money in the long run. These experts believe that the more you expect your business to perform, the more you risk losing money when you offer part of your business to investors. This distinction is perhaps the most abstract in the debt versus equity finance debate.
What is debt financing?
Debt financing means borrowing money for your business and paying it back with additional interest charges. Standard loans are a type of debt financing, as are many day-to-day financing options, including mortgages.
For example, let’s say you need $ 50,000 to launch your startup. If you get this money from a two-year loan with an interest rate of 10% compounded annually, then depending on the compound interest formula, you will owe $ 1,050 on top of your loan repayment. Here is the calculation of the monthly payment:
($ 50,000 + $ 1,050) ÷ 24 = $ 2,127.08
Benefits of debt financing
Here are some reasons why a business owner may seek debt financing:
- Independent decision making. Debt finance providers don’t have a say in how you run your business. Equity financing requires you to give your investor a stake in your business, which gives them a say in all key business decisions.
- No profit sharing. When you opt for equity financing, the stakes you give to your investor entitle him to a portion of your profits. With debt financing, your profits are entirely yours.
- Easy budget forecasting. Once the interest rate on your debt financing is set, it won’t change. That is why Estimates is much easier when you go for debt financing as compared to other types of financing. With unchanged monthly fees, your future expenses are more predictable.
Disadvantages of Debt Financing
Here are some disadvantages of debt financing:
- Refund. Unlike equity financing, you pay back the money you receive from debt financing. Anyone who has ever taken out a student loan or mortgage knows the risk involved in this arrangement. If you are going through difficult times, you may become unable to pay off your debt and find yourself soon dealing with debt collectors.
- Interest charges. Another key distinction between debt financing and equity financing is that only debt financing generates interest charges. Depending on the interest rate and the length of your loan, your monthly interest charges can become quite large, and you need to keep your expenses as low as possible while you grow your business. However, all interest you pay on debt financing is tax deductible. In the long run, this deduction could outweigh the immediate financial burden.
- Responsibility. Even if your business structure limits your personal liability in the event of a lawsuit, some debt financing providers will require you to put your assets as collateral. If you don’t pay off your loan, your lender may be able to acquire your assets.
What is equity financing?
Equity financing is the sale of a portion of the equity in your business to an investor. The investor provides the capital that your business needs to grow while receiving an equity stake in your business.
For example, if your startup needs a substantial infusion of money to get started and run, you can search angel investors or venture capitalists who, in exchange for their capital, will want to take a stake in your business. If you decide to give your new investor 30% ownership of your business to receive their capital, that investor now has a seat at the table for all future business decisions.
Benefits of equity financing
Here are some reasons why you may prefer equity financing as a source of capital:
- No refund. Investors will not ask you to return the principal they give you when you get it through equity financing. The logic is that investors will fund your business in the hope that it will grow significantly. The big buyout your investor will receive in the long run, whether from you or another company that bought yours, theoretically makes their risk profitable.
- No interest charges. Since equity financing does not require repayment, you don’t have to pay any interest charges.
- More capital. When you choose to grow your business through equity financing, you gain capital. You also increase your ability to raise even more capital since, unlike other types of financing, you will not spend any money to obtain equity financing. Since you’ve kept all of your money, the amount of money you can spend on additional resources is unchanged.
Disadvantages of equity financing
The downsides to equity financing all relate to the property you give to your investor:
- Decision making. Whenever you get equity financing, your funding source subsequently owns a portion of your business. As such, you will need to consult with your funders on all key business decisions.
- Sharing of profits. A portion of your profits will go to your investors. If you offer an investor 30% ownership in exchange for their capital, you will need to set aside 30% of your profits for that investor in the future.
- Difference of opinions. You and your new shareholders will not always be on the same wavelength about how the business should be run. If you don’t have strategies in place to resolve these conflicts, this could cause huge conflicts within your organization.
Questions to consider before choosing debt or equity financing
Before choosing between debt financing and equity financing (or obtaining financing by both by determining a rate of endettement), you can ask yourself the following questions:
1. What is more important: decision-making power or minimal debt?
If you’re the kind of business owner who can’t stand the idea of sharing decision-making power with someone else, you might consider debt financing as a solution. However, if you are budgeting and determine that you might have a hard time repaying debt financing, it may be best to play it safe and accept the loss of control that comes with equity financing.
2. What are the current interest rates on debt financing?
It can be easy to forget the impact of interest rates about your debt financing options. After all, the $ 1,050 interest on a $ 50,000 loan in the example above is only 2.1% of the total loan value. However, any additional expense can make or break a new business, as some businesses can take years to become profitable.
3. How much capital do I need and what are the consequences?
If you need so much capital that you’re already worried about paying off the debt financing, equity financing may be a safer bet. However, when you provide equity in exchange for a large amount of capital, your investors are likely to need a proportionately large share of your business. If your investor demands more than 50% ownership of your business, your decision-making power may even take a back seat.
4. Will my business structure easily allow equity financing?
Since equity financing requires you to give ownership shares to your investors, not all business structures can easily explore this avenue of financing. For example, if your business is a partnership, its ownership structure may not be flexible enough to accommodate new shareholders. You can always change your type of business transaction, but it’s a long process.
5. Can I actually find equity financing?
Entrepreneurs often assume that equity financing is readily available, but this is not always the case. Not all entrepreneurs find investors interested in their business. Other entrepreneurs will only find investors after months of research, so this might not work for you if you need the cash quickly.
On the other hand, debt finance providers will lend money to virtually any eligible entity. If you have a strong credit history, come up with a compelling business plan, and prove that you can repay the loan, you could be in good shape for getting approved.
Whether you ultimately opt for debt financing, equity financing, or both, business growth could be quick to follow.