Small businesses often need money. This is especially true for companies in the beginning stages of development. Finding that money can be difficult. Tighter lending standards and venture capitalists still recovering from the recessionary fallout are producing an environment in which funding is a challenge. There are two basic types of funding available to small businesses - debt financing and equity financing. As a small business owner, which is best for you?
Purchasing a home, a car or using a credit card are all forms of debt financing. You are taking a loan from a person or business and making a pledge to pay it back with interest. Debt financing for your business works in a similar way. As a business owner, you can apply for a business loan from a bank or receive a personal loan from friends, family or other lenders, all of which you must pay back. Even if family members lend you money for your business, they must charge the minimum IRS interest rate in order to avoid the gift tax.
The advantages of debt financing are numerous. First, the lender has no control over your business. Once you pay the loan back, your relationship with the financier ends. Next, the interest you pay is tax deductible. Finally, it is easy to forecast expenses because loan payments do not fluctuate.
The downside to debt financing is very real to anybody who has debt. Debt is a bet on your future ability to pay back the loan. What if your company hits hard times or the economy, once again, experiences a meltdown? What if your business does not grow as fast or as well as you expected? Debt is an expense and you have to pay expenses on a regular schedule. This could put a damper on your company's ability to grow.
Finally, although you may be an LLC or other business entity that provides some separation between company and personal funds, the lender may still require you to guarantee the loan with your family's financial assets.
If you think debt financing is right for you, the U.S. Small Business Administration works with select banks to offer a guaranteed loan program that makes it easier for small businesses to secure funding. Go to the SBA website to learn about those programs.
The public does not understand equity financing as well as debt financing, because equity financing involves investors. You could offer shares of your company to family, friends and other small investors, but equity financing often involves venture capitalists or angel investors. The popular ABC series, "Shark Tank," highlights entrepreneurs who present their business ideas to a group of investors in an attempt to secure equity financing.
The big advantage of equity financing is that the investor takes all of the risk. If your company fails, you do not have to pay the money back. You will also have more cash available because there are no loan payments. Finally, investors take a long-term view and understand that growing a business takes time.
The downside is large. In order to gain the funding, you will have to give the investor a percentage of your company. You will have to share your profits and consult with your new partners any time you make decisions affecting the company. The only way to remove investors is to buy them out, but that will likely be more expensive than the money they originally gave you.
Which Funding Method Should I Choose?
Often you will not have a choice. Formal equity financing is difficult to secure especially for small, early-stage startups. Venture capitalists are looking for companies with global reach. Angel investors, those who fund on a smaller scale, are often looking to invest a minimum of $300,000 and possibly a 50% stake in the company, especially if it is in the very beginning stages, according to an article released by Entrepreneur.com. If your company is a startup serving a local market and does not need large-scale funding, debt financing is probably your best, and perhaps only, option. Larger startups often combine debt and equity financing to reduce the downside of both types.
The Bottom Line
The type of financing you seek depends largely on your startup. If you are just getting started, consider a loan from family, friends or a bank. As you grow and reach a larger market, equity funding may become a more viable option if you are willing to give up a portion of your company. (For related reading, see "Should a Company Issue Debt or Equity?")