The Oldest Business Funding Question – Debt Versus Equity
There is a constant debate over the use of the twp main types of small business loans and which is more useful. In truth they both have their place, and rather than argue over the attributes of each, businesses are wise to use a combination of both at opportune times during their growth.
Small, or new business owners may not fully understand what the differences are, and some, new to the business financing realm may not even know what equity financing is. The term equity is bandied about in personal loans regarding the value of assets versus outstanding loan amounts placed on it, and equity is acquired much the same way in businesses. However, equity lending is not done on a personal level so understanding how the equity can be used to fund a business is something all newcomers should understand.
The Two Sides of a Coin
Debt lending is the side of business financing almost everyone is familiar with. It is a straightforward loan that works much the same for businesses as it does for personal loans. It is a set amount of money “mortgaged” on the business or is other variable assets set to play out over a period of time and charged an interest structure for repayment.
Debt lending has many qualities that make it an attractive form of business financing the first of which is the all important build up of credit for good performance in repayment. The downside of debt financing is that it requires repayment that can take away from a business’ profits, usually requires collateral in the form of business assets, or personal assets to secure the loan, and perhaps the most difficult aspect of debt financing of all: debt lenders are notoriously conservative. It is up to the business owner to prove the value of their company, their ability to repay a loan, and the financial prospects of their company.
Another positive value of a debt loan vs. an equity loan is that the interest paid on a debt loan is tax deductible. Perhaps an even bigger incentive to choose a debt loan is that debt loans offer lenders no control over the way the business is run.
Equity loans are far less understood by many business owners. These types of loans can be made by private investors as well as banks, and do not involve payment structures or interest because, hang on to your seats-you don’t have to pay them back! Whoa, before you go dancing off to your local finance institution to plunk down a request for equity financing here’s the catch: Equity financing is an exchange of financing in exchange for a piece of your company. You are selling off part of the value of your company.
This is basically like taking on a partner, although some financing is offered without actual control, you will be paying an equal amount of the profits of your future business profits to your new “partner.”
Whether equity financing comes with an active or silent partner many business owners are reluctant to sell off part of their future profits. Another downside is that since there are no “payments” as in debt financing there is nothing to deduct on your businesses tax filings.
Another aspect to take into consideration is that equity financing, often known as venture capital, is usually only offered if a business can prove it has the potential to use that money to create an explosive growth so that its performance escalates, thereby providing a great return on investment for the lender.
Which Type of Financing to Choose
Equity financing can be difficult to obtain in some situations. New businesses usually neither have the equity built up, nor the track record to judge a business’ performance to obtain such a loan. That however, is also the problem for new businesses when applying for a standard debt loan. Chances are, if you have a strong business plan, good concept, and any equity value at all in the form of inventory, building, or equipment you can find private investors that might be easier to obtain than bank debt financing.
Equity finance companies are also more competitive and aggressive. They can take more chances because the potential for payoffs are greater. With debt financing the return on investment is a set figure-no less, no more than the original contract. With equity financing if the business really takes off the financer stands to reap great rewards.
One argument is that debt financing, if at all available, offers business owners the most security, less potential loss over time, and no loss of control over company direction or operation. It would seem that it is the best choice in all situations, and yet businesses big and small who understand both forms of financing well know that there are times when equity financing simply makes more sense.
If you do not have enough profit to repay a debt loan, equity financing makes good sense. It can offer you the means to expand or implement new procedures to maximize your income potential where you can then apply for a more standard type of loan. Startups with a dynamic business plan have the most to gain from equity financing. They very often cannot afford to repay a debt loan, but will in the foreseeable future have massive profits.
Established businesses that find themselves stagnated and in need of a boost of cash to expand may not be in a position to pay monthly payments on a debt loan either. They may also find banks even more reluctant to lend money on the chance they will improve than they are willing to finance a startup. In those cases an equity loan works excellently.
Once a company, regardless of its duration is capable of acquiring and maintaining payments on a debt loan it should seek that type of financing. Even venture capital lenders will shrink away from a company that never grows to the point where it can afford to take on a debt loan. Companies that are ever expanding and always on the edge of fiscal stability will look like risks to either side of the coin so it is important to have lengthy periods of time where the business is operating in a healthy profit margin before attempting to get further loans of either type.
Each individual businessman will have their own ideas of the perfect combination of debt and equity financing. Businesses using both to their maximum benefits are well on their way to a solid future. Instead of thinking about the issue as debt VS. equity financing, business owners should think of it as debt AND equity financing for a secure future.