Starting a new business usually requires money for activities pertaining to entrepreneurial ventures that may include developing products or services, feasibility studies, market studies, building prototypes, identification of markets and customers, procuring/leasing facilities, employee hiring, etc. The illustrative graph included in related article Why, How, Where and When Entrepreneurs Make Money demonstrates the money requirements at the initial stages of business.
Despite multiple funding options, getting funding is not easy, and business owners and entrepreneurs may have a limited understanding of the pros and cons of available funding sources. Let’s examine two common types of startup funding: Debt and Equity.
Existing Business vs Startups
Existing businesses have different funding requirements, backgrounds, perspectives, and track records than startups. Existing businesses have the benefit of established track records with detailed numbers. They can easily justify their finance needs and better qualify for funding based on concrete plans for expansion into new territories or business sectors, backed by prior experience.
Startups are usually new businesses still taking shape or entrepreneurial ventures based on a new product or service offering. Background information is unavailable, success is doubtful, and sustainability can be risky. As a result, only a limited number of investors are willing to financially back startups.
In simplest terms, a loan is money received today to be repaid in future along with interest (based on pre-determined criteria).
Multiple sources are available for loans. A person (family member, friend) or a business (bank, investors, venture capitalists, etc.) can act as a lender, based on the trust between the lender and borrower or a convincing business plan. Loans can be easy to secure (from friends or family) with little paperwork, but can be quite complex if sourced from external sources as much persuasion and formalities may be needed.
The advantages of loan funding include:
- Loans are easier to understand and apply for if the funding amount is relatively small to moderate.
- Lenders usually don’t have any control or say in business decisions as long as repayments are timely.
- The lender’s involvement ends as soon as the borrower repays the loan (with interest).
- Few countries offer tax benefits on interest paid on business loans.
- Term-based loan repayments provide easy-to-project numbers for business activities in the future, enabling a robust track record and fulfilling accounting needs for future business/funding requirements.
- Governments often offer subsidized loans for small businesses (Related: An Introduction to Government Loans). For example, the US Small Business Administration (SBA) offers SBA loan programs.
Funding amounts may vary according to the different loan providers (and regulations involved), and may sometimes pose a challenge:
- A family member willing to offer an interest-free loan may need to consider gift tax limits. The lender may be forced to charge a minimum IRS-set interest rate even to other family members.
- An individual lender may need to fulfill set regulations and necessary paperwork.
- A loan from an angel investor may have set limits on either side. Your startup-funding requirement of $100,000 may be too small for consideration by a venture capital fund that only loans to businesses needing a minimum of $5 million.
Additionally, lenders may request mortgage(s) or guarantee(s) from other associates/family members directly or indirectly part of the startup business to secure their lent money and avoid risks.
In equity funding, business owners offer a portion of their business to investors in exchange for a desired amount of funding.
Benefits of equity funding:
- Risk is indirectly taken by the investor(s) providing the funding.
- There is no requirement to repay the funds if the business goes bust.
- It provides a recognizable valuation to a startup business.
Challenges of equity funding:
- It can be complex to understand.
- Business owners sacrifice part of their business share to investor(s).
- Important decision-making will require investor(s) approval.
- There are high costs associated with the legal, administrative, and procedural formalities.
- The funding time period can be very long.
- There are a limited number of investors willing to help start-ups.
- Maintaining investor relations is paramount despite their positive/negative influence on a business, as the overall reputation of the startup owner may be at risk within the small pool of equity investors.
Debt or Equity?
Securing funding of any type is not just about wanting ‘x’ amount of money and applying for it. Thoughtful consideration with a systematic approach can help one make the right selection. Debt forces obligations of future payments whether the business is a success or a failure. While equity takes away part ownership, limiting the freedom of a business owner to operate as he or she wants. (Remember, Apple, Inc. [AAPL] founder Steve Jobs was once fired from his own company due to differences with management and investors.)
- Choose a duration for your business venture (e.g., number of months before roll-out). Be prepared with an exit strategy if things don’t work out in the decided timeframe. Your funding requirements can come down drastically once you finalize the time horizon of your business venture.
- Decide your capital requirements over a suitable business timeframe (three months, six months, one/ two/three years).
- Accumulate all your personal savings. Add to it the projected income from your existing job or alternate income sources (such as rentals), over the desired duration of startup venture.
- Add to it the zero-/low-cost funding available from willing family members and friends (post-tax and interest considerations).
- Arrive at the deficit amount, which will now be an accurate indicator of your realistic funding requirement.
- If your required funding amount is moderate, go for the comparatively easier debt financing, provided you can afford the interest payments and terms of the lender.
- Moderate to large-sized funding requirements may make equity financing more attractive (after considering the complex nature of the deal and partial loss of business ownership). High-growth companies often go for equity financing, predicting higher future returns based on large investments.
- Larger-sized funding requirements may mean a business owner will want a mix of both debt and equity funding.
- Explore a time-bound mix. Start with a small to medium-sized loan, and if your startup shows signs of success by the end of the debt duration, go for larger equity funding.
The Bottom Line
No lender will fund a business unless there are sure signs of success and a perceived guarantee of returns. Startup owners should approach lenders with concrete business plans, clear business models, growth paths, and projected returns. Finally, convertible debt and convertible equity are other possible funding options that can be considered.