Debt vs Equity funding
In this guide, you would be able to understand the difference between the two main types of funding: equity funding and debt funding.
By now you may have done your own research and read articles about company funding. And with this you may have decided that all you need is just a loan to rent the office and start your business. But do you really know what type of funding you need or which one is the right option for you?
Acquiring a small business loan or investment from an investor may sound fantastic, until you’re face-to-face with deadlines, profit targets and huge bills. It can be a bit overwhelming at first when looking to secure funds for your company, and how to approach all the different kinds of funding options and investors. However, funding does not always have to be this complicated and the best way to avoid the complexities of company funding is to understand it before you move forward.
In this guide, you would be able to understand the difference between the two main types of funding: equity funding and debt funding. By the end, you will have all the information and answers to these questions like:
- Do I need funding for my startup right now?
- What is the difference between equity funding and debt funding?
- What kind of equity or debt funding is the best for my company?
So, let’s begin with all these answers and more!
Startups and small businesses usually need money at the beginning until they have reached a stable financial level. This is mostly because these companies are in the initial stages of their business development and may not have many customers yet.
In order to secure the best type of funding to give you the confidence to grow your startup, you should know which type of funding is the best. Let us understand both debt funding and equity funding in details.
What is debt funding?
Buying a car, a home or even using a credit card are all forms of debt funding. In short, debt funding is taking a loan from someone and then paying them back with interest. This method is the same for businesses as well. If you are a business owner, you can receive a personal loan from your family, friends, or other lenders.
You can also apply for a business loan from a bank, which you would have to pay back after a period of time with some interest. As a matter of fact, even if you get a loan from your family or friends, it is important for them to charge a minimum interest rate as per the IRS for avoiding gift tax. Even though you might have to pay a little extra for the debt funding, the numerous advantages that come along can make it all worth it.
The very first perk is that the lender would have no control over your company, and as soon as you have paid the amount back, you would have no relationship with the financier. Other than this, you can deduct the interest you pay in your tax return. You would also be able to forecast all your expenses as the loan payments won’t fluctuate.
The problem of debt funding is that it is hard for anyone who is in debt, which is used against your future ability to give back the funds you received. Obviously, when you were taking the loan, you convinced the lender that your business would be a success, and with the profits, you would pay them back.
But, let us say that your startup doesn’t go smoothly, and your company is going through a hard time. Then how do you expect to pay them back? Keep in mind that debt is an expense, and you would need to pay for all the expenses on a monthly basis. This is especially hard if you are not making a profit, which will hinder your ability to grow.
In the end, even though you might be an LLC and have your personal fund and company fund separated, the lender would still need something as a guarantee for the loan. Usually, they take the guarantee with your personal financial assets.
What type of debt is right for my small business?
Various kinds of debt funding are available that serve different uses. Debts with the lowest interest rates are the ones that are backed with some form of collateral. This means that the company gives equipment or assets that are receivable as a guarantee. On the other hand, unsecured debts like credit cards are a lot more expensive and do not need any collateral.
If debt funding is not the right match for you, you may consider equity funding for your company. Let us see the other option of equity funding, as explained below.
What is equity funding?
It is common for people to get confused between debt funding and equity funding, as equity funding also involves funds. However the money received in equity funding is from investors who take a share of the company. And these are not usually investors like your family, friends, or any other small investor who you might offer shares of your company for the funding. Equity funding for companies often involves angel investors and venture capitalists.
The best thing about obtaining equity financing is that the investors are the ones who are sharing the risk. You would also have enough cash in hand to grow your business as there wouldn’t be any monthly loan payments. Also, this means that if your company fails, you would not have to pay anything back to the investor. Ultimately, the investors look at everything and take a long-term approach by understanding that a business needs time to grow.
Now that you have learned about the upsides, the downsides are also something that should be considered. For obtaining equity funding, you would also need to give a percentage of your company to the investor. This means that you may need to regard them as partners when there are major decisions that would affect the business.
Other than this, you would also need to share the profits that come from their share of the company. And the only way to remove the investor from the loop is to buy the percentage of your company that they own. But this may be expensive and much more than what they gave you initially. Moreover, obtaining equity funding is also not as easy as securing debt funding.
Advantages and Disadvantages of Debt Funding
Now let us understand the pros and cons of debt funding in details.
Pros of debt funding
- Debt funding is a flexible category where you can choose from various types of business loans. There are many choices in the amount of money you can get and even in how much time you take in making the repayments.
- Getting a business loan would not leave a permanent burden on how your company would be operated, other than the loan payments you owe.
- You would be able to control the exact flow of cash and monitor how the capital is spent. A few of the lenders do impose particular limitations, but it still depends on what you do for your business.
Cons of Debt Funding
- In case you cannot make the loan payment, the assets of your business may be ultimately seized by the lender.
- It can be difficult to obtain a loan that you want, depending on your financials and credit score.
- For the cash you get, you need to pay extra for it. But if you get everything right for how much you borrow, you can get double or even triple the amount back.
Advantages and Disadvantages of equity funding
After understanding the points of debt funding, let us understand the pros and cons of debt funding in details.
Pros of Equity Funding
- In case your business fails, you would not need to pay anything back to the investors.
- Connecting with the right investors, you would be able to obtain industry connections, wisdom, great experience, and more. And these relationships can help you a lot for the development of your company.
- You do not need to pay any interest for the equity funding you get. And this means that you would not have to spend all your business profits for debt repayments and you would have enough cash to develop your company.
Cons of Equity Funding
- As compared to the time period in obtaining debt funding, equity funding takes a lot of time.
- For obtaining the equity funding, you are giving away the ownership of the business, and with this, you are also giving away some the decision-making power. This means that you would have to consult with the investors whenever you want to make a significant decision.
Factors to Decide
If you are still having some difficulty in choosing between equity or debt funding for the best for the business, here are a few things that you need to ask yourself:
QUESTION 1: How soon do you require the funding?
In case you require the cash immediately, then debt funding is the right choice for you. A business can get loans very easily and fast – even in a matter of hours, if you have applied in the right place. While on the other hand, equity funding involves looking for suitable investors, showing your business plan, gathering the legal papers and much more.
Nonetheless, if you do not need the capital immediately, you can choose any of the options that work for you the best by approaching both ways. If you are about to take a loan, just ensure that the loan is affordable and it would not burden your financials and business later on.
QUESTION 2: How much funding do you require?
In case you are looking for a little amount or do not need a lot, then debt funding is more suitable for you. This is also because equity funding doesn’t come with small values, but you can get loans that are as low as $10,000 for a business.
If you are looking for an early stage investor, they may be able to fund you with a large amount of capital, but expect they may want anywhere between 30-50% of the company.
But it is not necessary for you to obtain equity funding just because you need more cash, as debt funding can also be the right choice, depending on which you find better as per your needs.
QUESTION 3: Seeking for something more than money?
If so, then equity funding is better, as debt funding is purely transactional where you borrow money and then you pay it back with the interest payments. On the other hand, equity funding would give you access to all the expertise, contacts, and even knowledge of the investors.
In short, with equity funding, you would be able to create a relationship that would have an enormously positive impact on your company and business ideas, as long as the investors you choose are the right people. But if what you are looking for is just more cash in your bank account, debt funding might be what you need.
QUESTION 4: Do you mind sharing your company?
If so, there are a few entrepreneurs who want to keep their company to themselves, and that is alright. If you do not want to give control of how your business runs to investors, equity funding is not for you. And if you are happy to welcome the expertise and experience of the investor, then equity funding is better. It all depends on your path of work and future plan for your business.
QUESTION 5: How successful and big do you want your company to become?
Venture capitalists and angel investors normally search for businesses that have potential to grow and become a global brand some day. So, if this is your goal, then equity funding is the one you need.
However, if you just want to own a small business and run it locally, and you do not need partners or a board of members, then debt funding may be more suitable.
To find the right type of funding is a massive deal for building a successful business, and it would also have a lasting and profound impact on how your business operates. You may consider obtaining equity funding and debt funding together as per your time and funding requirements. A lot of business use both and are successful as well.
Which Method Should you Choose?
In the end, you might not have to make hard decisions at all, and the reasons are simple. You just need to identify what you would like from your funding. In case your startup is a small local company and you have no intentions to add shareholders, debt funding is the best option. On the other hand, if you want a knowledge, experience, and larger funding, equity funding is for you.
Formal equity funding can be hard to obtain, particularly for those who do not have a comprehensive business model and growth potential. But it is not impossible if you have the right idea and you have made the effort to present it the right way. Hence, if you know that your company is worth the best, you wouldn’t need to worry on how to gain equity funding from investors.
You don’t have to stick to just one option. As your company grows, you can take up both kinds of funding, like many of the large companies. These large companies easily combine equity financing and debt financing to grow faster and make use of the advantages of both sides. Depending on your needs and choices, you can use both.
Business Potential with Investment Funding
Any company that does not have a funding source would fumble under the weight of its own finances. Basically, funding is fuel for a company, and it runs based on the financing. As mentioned above, there are two types of funding and a business can take any method to get the funding.
The funding that the business chooses would depend entirely on the desire of the business to be in debt, how solvent the owners are during the establishment of the company, and the amount that the company needs to originate and sustain itself through the various events of a business cycle.
The reasons funding is important are:
- Seed Money: To get an office, equipment, website, business cards and everything else, you need money. For starting a business, seed money is raised from an investor or even a bank.
- Cash Flow: The business needs to bring in cash to survive, and if there are employees, they need to be paid as well. Moreover, you would also need to pay for the utilities, bills, and the business would not easily earn profits in the beginning to cover all these.
- Expansion: It is obvious that you started a business to grow, and when the business grows, so do the employees. And with this, you would need to pay more for space, electricity, salaries, etc. Plus, you might not have all the money to have this done.
- Repairs: Accidents can happen any time and you need to be prepared for it.
A business can try out many options for getting the funding, and it is not tough to get a traditional bank loan. However, it should be noted that to attain funding, you would need to present your business plan to the investors. You have to be confident and know all about the business plan, inside and out.
If you do not want the equity funding or the bank loans, you can also obtain the funding from your family and friends. Just ensure that you pick the right option that would help both you and your business.
Now that you know about the two main types of funding, debt funding and equity funding, many options come under these two. If you have understood and decided the type of funding that you need, it is time to select the place from where you would get the desired funding.
The different types of investors are friends, family, VCs, government, angel investors and many more from which you can select and request the funds from. And although the entire process of finding the right investor might be time-consuming and tiring, it is better to take time in the beginning to choose the best fit, so there isn’t any trouble in the future.
The next guide would explain the details regarding the various options for obtaining both equity funding and debt funding. But before that, take time to think and decide the kind of funding that you need and what future you are looking at both for you and your company.