Debt vs. Equity: What’s the Right Type of Financing for You?

As you prepare to grow your business, one of the first things you’ll consider is funding. Most entrepreneurs base their decision primarily on the repayment terms: what sort of interest/return does the financier expect and when the funds are expected to be paid back.  Some entrepreneurs opt for equity because the repayment timeline is less rigid (which gives a false sense of “free money”). Others choose debt because they don’t have to give up ownership control.

There are many more differences between debt and equity, and the decision to choose one or the other becomes clear when you consider your business and growth needs.

Repayment Structure: Debt is more structured in its payback. This can become a problem if you have trouble making payments. Banks, especially, are less forgiving about missed or late payments than other types of funders.  Non-profit and individual lenders may be willing to work with you. Equity has greater flexibility in repayment to investors: the investor gets repaid when funds are available. If your business is struggling, the investor will forgive slow repayment as they don’t want to detrimentally drain your cash flow.

Cost of Capital: Debt is typically is less expensive than equity. While the repayment terms are different, you’re still paying for the use of the funds in the form of interest or returns.  The cost of using someone else’s money is traditionally less with debt/loans (unless you’re using a credit card).

Ownership Control: The upside of loans is that you do not have to give up management or ownership control of your business.  As part owners of your business, equity investors not only have a stake in your business, they may have opinions about how you do things and can offer unwelcome advice.

Advisors: That said, some entrepreneurs want the advisory support.  While all financiers want you to succeed, not all have the resources to provide mentorship and advice. Equity investors often offer business advice. Many non-profit lenders offer technical assistance.

Tax Implications: Debt lowers your tax burden. Income tax is based on net income (the bottom line); and interest expense related to debt reduces your income, thereby reducing the amount of taxes owed.  Distributions to investors are not considered an expense, and therefore do not impact your taxes.

Planning Future Growth: Some lenders will restrict the number of other loans you take because it increases their risk. When taking out a loan, ask about any covenants that would limit your ability to take future loan.  Often times, a growing business will take out multiple loans in order to grow to the next phase.

Spectrum of Success: What will it take for your business to succeed – perhaps, $100,000 is the minimum revenue you need to break-even, and there’s a probability that you could earn as much as $300,000. That’s a broad spectrum.  Other businesses either succeed wildly or flop altogether, with nothing in the middle: a binary outcome. The only successful outcome could be if the business is sold to a larger company. This may be true for some value-added food producers or technology companies.  With these types of speculative businesses, everyone (both equity investors and lenders) loses their money if the business fails. However, if the business succeeds, equity investors get better returns than the lender.  As such, a lender is not likely to offer debt for this type of business.

How are you financing your growth? If you need help preparing for investors, give us a call or send a note.