When you launch a business, funds are typically one of the major causes of friction. You need money to make money, but don’t necessarily have enough of your own to bootstrap or self-fund the venture.
At this point you typically face a choice between two essential types of funding: debt financing or equity financing. Each comes with its individual pros and cons.
Let’s investigate each in detail.
A Look at Debt Financing
Most people are pretty familiar with the concept of debt financing. It’s similar to the way in which many of us have purchased a house on a mortgage or car via an auto loan.
In debt financing, you take out a loan, whether a quick cash loan or a bigger small business loan, and use the money to build your business. You’re expected to repay the loan according to the particular terms agreed upon up front.
The biggest advantage of debt financing is that you don’t have to give up a stake in your business. The lender or lenders have no say in how you run the company.
They simply provide the cash and you repay the amount with interest. It’s a clean, hands-off situation that allows you to retain entire control of operations.
Debt financing also offers tax advantages. The interest you pay on your loan is tax-deductible, so it can help reduce your bill at the end of the year.
Although a tax deduction sounds nice, it represents only a portion of the interest you’ll be paying. Loans can be costly, especially if it takes you a while to repay them.
You’ll also likely be asked to provide some sort of collateral for the loan. Since your business may be new or nonexistent at the time the loan is written, your collateral will likely be a personal item: a car, home, etc.
The Lowdown on Equity Financing
The other big option is equity financing. If you’ve ever watched the popular ABC television show Shark Tank, then you’re familiar with this form of deal.
With equity financing, an investor offers you a certain amount of money in return for a percentage of the business. In other words, if you think your business or idea is worth $100,000, but you need $10,000 to get up and running, an investor may give you the amount in return for a 10 percent stake in the firm.
For entrepreneurs, the biggest benefit of equity financing is that you don’t have to pay any interest on a loan. You get to keep the entire amount of the money you’re given without any obligation to plan for complicated and costly repayment terms.
The obvious downside of equity financing is that you give up a percentage of your business. Should your firm grow into an operation that’s worth a lot more in the future, your initial equity offering could end up costing you far more than you were granted.
If, using the previously example, your company expands to a value of $10 million in a few years, that 10 percent stake you gave away for $10,000 would grow to be worth $1 million.
Equity financing is risky for both parties involved, but it can often be a smart choice. You may worry about giving up a stake in your business, just remind yourself that 10 percent of something is worth more than 100 percent of nothing.
In other words, if you don’t get the equity financing, you might not be able to launch the business at all.
There is No Perfect Solution
There is no perfect option that works across the board. Some entrepreneurs and their ventures are better structured for traditional debt financing; other owners will calculate that equity financing is apt to help them achieve their goals faster.
As you look for opportunities to start or expand your business, it’s crucial to perform suitable research and make sure you grasp the pros, cons, opportunities, and drawbacks of any option you’re considering. It’s also wise to surround yourself with people who have experience and wisdom you may lack.
In sum, it’s not the financing that will make or break you; it’s the value of the business idea and your work ethic. If you can combine a solid idea with a sound financing strategy, you’ll be successful.