Small Business Financing: Debt or Equity?

Small businesses often need money. This is especially true for companies in the beginning stages of development. 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?

Key Takeaways

• Start-up small businesses may use equity financing or debt financing to obtain money when they are cash-poor.
• A bank loan is a form of debt financing used by small business owners.
• Equity financing means allowing stakeholders to own part of the business.
• Getting a small business up and running often calls for taking out some form of debt.
• Some business owners use personal funds or take out debt in the early stages of forming their business.

Debt Financing

Purchasing a home, buying a car, or using a credit card are all forms of debt financing. You are taking a loan from a person or business and pledging to pay it back with interest. Debt financing for your business works similarly.

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 Internal Revenue Service (IRS) interest rate 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 authentic 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 regularly. This could put a damper on your company’s ability to grow.

Finally, although you may be a limited liability company (LLC) or other business entity that provides some separation between the company and personal funds, the lender may still require you to guarantee the loan with your family’s financial assets.

Equity Financing

The main difference between equity financing and debt financing is that 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 significant advantage of equity financing is that the investor takes all of the risks. 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. 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 initially gave you.

Important

If you think debt financing is right for you, the U.S. Small Business Administration (SBA) 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.

Which Funding Method Should I Choose?

Traditional equity financing is challenging to secure, especially for small, early-stage startups. Often you will not have a choice. Venture capitalists are usually looking for companies with a global reach. Angel investors, those who fund on a smaller scale, are often looking to invest a few hundred thousand dollars in new startups, but if you search for them, there are angel investors who also invest less.

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. More prominent startups often combine debt and equity financing to reduce the downside of both types.

What Is Debt Financing?

When you take out a loan to buy a car, purchase a home, or even travel, these are forms of debt financing. As a business, when you take a personal or bank loan to fund your business, it is also a form of debt financing. When you debt finance, you not only pay back the loan amount but you also pay interest on the funds.

What Is Equity Financing?

When you finance your business start-up costs with equity financing, you borrow money against the equity you have or future equity. Investors provide equity financing by essentially purchasing shares of your company.

What Is Better for My Business, Equity or Debt Financing?

The rewards of using equity or debt financing to fund your start-up costs depend on how much money you need and the size of your business. If you think you will only need a few thousand dollars to begin, it might be easier and cheaper to borrow money from a friend or family member, or even take out a small bank loan. If your company needs hundreds of thousands of dollars to get off the ground, equity financing may be a better route.

The Bottom Line

The type of financing you seek depends mainly on your startup. If you are just getting started and can begin with a small amount of capital, 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.