Raising Funds – Debt vs Equity Financing
Your business cannot run on thin air. To keep a company on its feet, you must figure out the best way to finance it. Securing funds is a challenge, especially during the development stages of small businesses. However, there are a number of options available. In general, there are two ways to finance your company – debt financing and equity financing.
Essentially, you are borrowing against your assets. Whether it is from a bank or from relatives, friends, and other personal relations, debt financing is acquiring funds by borrowing and promising to pay it back (with or without interest). Note that if borrowing large sums from personal relations, there is a chance that the amount will still be taxed.
There are three advantages to employing debt financing:
1. The ownership of your company is not diluted. Your financier (bank or personal) does not hold any stake in your business and business decisions.
2. It is relatively easy to plot out loan payments. Though your ability to pay back your debt depends solely on the future of your company – and its profitability – it is not so difficult to foresee and schedule loan payments to your financier. The payments are set.
3. Interest on your loan payments can be deducted from tax.
However, depending on the forecast for your company, it may be difficult to secure the type of loan you need. Make sure to be wary of restrictions on certain types of loans and plan before you borrow.
With equity financing, you are allowing other companies and individuals to own a stake in your company in exchange for a certain investment. This may entail offering company shares to personal relations or even bigger firms like venture capitalists. The involvement of these third parties in business decisions depends on the contract or deal forged.
There are three advantages to choosing equity financing:
1. Investors take on all or majority of the risk. Aside from there being no interest charged on the amount contributed, should your business fail – your assets are not on the line.
2. The view stakeholders take is more long-term. Rather than putting tight restrictions on returns like loan payments to banks and other institutions, in equity financing potential investors see it as a long term investment. The growing of a business cannot be done in a snap of a finger.
3. Company cash flow is less restricted. Since you will not be making loan payments to any individual or institution, you will not have to factor this in to expenses.
One critical disadvantage to equity financing is the fact that you will have to “sell” a part of your company to your investor. In essence, they will earn from your profits. To end your relationship with them you will have to buy them out of the company – in most cases, this proves to be a much larger sum than their initial investment.
Keep in mind how quickly you need the financing, how much you really need, and the scheme you would like to employ to execute whichever type you settle on.