Choosing between debt and equity financing

Debt Financing

Borrowing money to finance the operations and growth of a business can be the right decision under the proper circumstances. The owner doesn’t have to give up any control of his business, but too much debt can inhibit the growth of the company.

Advantages

  • Retain control. When you agree to debt financing from a lending institution, the lender has no say in how you manage your company. You make all the decisions. The business relationship ends once you have repaid the loan in full.
  • Tax advantage. The amount you pay in interest is tax deductible, effectively reducing your net obligation.
  • Easier planning. You know well in advance exactly how much principal and interest you will pay back each month. This makes it easier to budget and make financial plans.

Disadvantages

Debt financing has its limitations and drawbacks.

  • Qualification requirements. You need to have a good enough credit rating to receive financing.
  • Discipline. You’ll need to have the financial discipline to make repayments on time. Exercise restraint and use good financial judgment when you use debt. A business that is overly dependent on debt could be seen as ‘high risk’ by potential investors, and that could limit access to equity financing at some point.
  • Collateral. By agreeing to provide collateral to the lender, you could put some business assets at potential risk. You might also be asked to personally guarantee the loan, potentially putting your own assets at risk.

Deciding factors

  • How important is it for you to retain full control of the business?
  • How important is it to know precisely what you’ll owe in monthly payments?
  • Are you comfortable with making regular monthly payments?
  • Are you able to qualify for debt financing? How is your credit history? Do you have a good credit rating?
  • Do you have collateral you can use? Are you comfortable with using it?

Equity Financing

With equity money from investors, the owner is relieved of the pressure to meet the deadlines of fixed loan payments. However, he does have to give up some control of his business and often has to consult with the investors when making major decisions. In the case of higher amounts, Rosemberg’s approach provides companies with fast and direct access to public capital without having to go through a complex and costly process to obtain a listing. This means that companies that are in an early investment phase will also have other funding options than only through venture capital or private equity.

Advantages

  • Less burden. With equity financing, there is no loan to repay. This offers relief in several ways. First, the business doesn’t have to make a monthly loan payment. This can be particularly important if the business doesn’t initially generate a profit. This also frees you to channel more money into growing the business.
  • Credit issues gone. If you lack creditworthiness—through a poor credit history or lack of a financial track record—equity can be preferable or more suitable than debt financing.
  • Learn, gain from partners. With equity financing, you might form partnerships—informal, perhaps—with more knowledgeable or experienced individuals. Some might be well connected. If so, your business could benefit from their knowledge and their business network.

Disadvantages

  • Share profit. Your investors will expect—and deserve—a piece of your profits. However, it could be a worthwhile trade-off if you are benefiting from the value they bring as financial backers and/or their business acumen and experience.
  • Loss of control. The price to pay for equity financing and all of its potential advantages is that you need to share control of the company.
  • Potential conflict. Sharing ownership and having to work with others could lead to some tension and even conflict if there are differences in vision, management style and ways of running the business. It can be an issue to consider carefully.

Deciding factors

  • If your creditworthiness is an issue, this could be a better option.
  • If you’re more of an independent solo operator, you might be better off with a loan and not have to share decision-making and control.
  • Would you rather share ownership/equity than have to repay a bank loan?
  • Are you comfortable sharing decision making with equity partners?
  • If you are confident that the business could generate a healthy profit, you might opt for a loan, rather than have to share profits.

Source: Jim Woodruff,chron.com

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