Entrepreneurs often take it for granted that the financing they need to get and keep their ventures afloat will come directly from the revenues they generate. But in many cases, your income won’t be enough to keep pace with what’s needed to support your operations. Some small businesses turn to debt or equity capital as a source of financial help. So let’s take a brief look at whether it might be better to pay with cash interest or with company stock for the funds that can help your business succeed.
What is Debt Capital?
The decision to finance your small business by taking on debt will involve at least one type of loan. Some organizations have multiple loan obligations, with the most common sources of debt capital taking the form of:
- Private loans acquired through family members or friends
- Credit card advances, home equity lines of credit, and other personal loans
- Business loans from organizations like the Small Business Administration
- Commercial bank loans
While private loans often come with the advantage of lower interest rates or more flexible repayment terms, all forms of debt capital allow you to maintain control over your business. And that’s a key point. Because when you pursue debt financing, you may owe someone money, but you won’t have to share profits or be answerable for your business decisions.
Trouble in Startup Paradise
The trade-off for the professional autonomy that debt capital provides is short-term - and sometimes long-term - financial obligation. Your loan issuer won't have a direct claim on the money you make, but they will have the right to demand that you begin repaying your debt immediately with regular loan payments. And that can sometimes pose a problem for new or fledgling operations with minimal income.
If your debt capital has been earmarked for startup costs like equipment or inventory, your business may not generate enough sales early on to cover rent, utilities, wages, and other monthly operating necessities. Add one or more large loan payments to the mix and you run the risk of not meeting your debt obligations, damaging your credit rating, and making it difficult to borrow funds in the future.
Some of the other problems often encountered with debt capital funding include:
- impaired family or personal relations if you renege on a private loan,
- loss of control over your company’s debt ratio - and an increased risk of bankruptcy - if you take on too many loans, and
- the possibility that you could lose personal assets pledged as collateral for a business or commercial loan if you default on payments
On the upside, taking advantage of debt to help finance your company usually means you’ll be able to claim loan interest amounts as a tax deduction at the end of the year.
What is Equity Capital?
In small business terms, equity is just another word for ownership. When you choose to finance your venture with equity capital, you’re essentially exchanging a certain amount of ownership in your business for a welcome infusion of cash.
Like debt financing, there are a range of equity capital sources to choose from:
- you can invest your own personal funds into your business (an amount that will show as owing to you in the owner’s equity account of your bookkeeping records),
- you can approach friends or family members who may be interested in investing (buying shares) in your company, and
- you can seek out an angel investor, venture capitalist, or some other professional business investor
The biggest advantage of using equity financing for your startup needs is that you can get your business underway without the burden of debt. Unlike a loan that requires money to be paid out right away, investors are usually rewarded with a share of the profits only if and when your company reaches a certain level of financial achievement.
Equity Pros and Cons
Selling one or more investors on your business carries other benefits as well. If the risks have been properly outlined and your venture fails, you won't typically have to repay invested amounts. Additionally, many professional financiers offer huge value in the form of seasoned business advice – advice that can mean the difference between your enterprise thriving and not surviving.
It’s important to remember, however, that equity investors will own a portion of your organization. And that means you'll have to be prepared to not only share the wealth, but to relinquish a certain amount of control. Leveraging equity capital requires that you run your business accordingly. If decisions aren’t being made in the best interest of your investors, you could find yourself in legal trouble.
Individual circumstances (think type of business, tax situation, and credit standing for example) usually determine whether debt or equity funding is the better choice for your business. Many companies benefit from a mix of both types of financing. And that's why seeking professional consulting advice can be a wise move when assessing and planning for capital needs.
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