When getting ready to launch a new business, you must find the thousands — sometimes hundreds of thousands — of dollars often required to get started. Options for startup capital include debt financing and equity financing. While you can pursue both, you should understand the difference before you make a decision.
In finance, a company’s capital structure consists of debt and equity. If you look at a statement of shareholder equity, you will see that equity is calculated as the difference between the value of the business’s total assets and liabilities. Debt financing and equity financing both have pros and cons. The choice depends on your startup’s financial situation and your goals as a business owner.
Debt financing involves taking out a loan to fund your startup. As with any loan, you pay back the principal with interest over a specified time period. Term loans and lines of credit are two common types of business loans. This section examines the pros and cons of taking on debt. [Looking to borrow money? Check out our best picks for small business loans.]
These are some reasons a business owner might seek debt financing:
>> Learn more: How to Avoid Shady Small Business Lenders
These are some drawbacks of debt financing:
Equity financing entails selling part of your company to an investor. The investor receives an ownership stake in the business in exchange for providing the capital your startup needs for growth.
Startup investors include angel investors and venture capitalists. The main difference between angel investors and venture capitalists is that angel investors are often individuals that provide early-stage funding, while venture capitalists are firms that step in at a later stage. This section will weigh the pros and cons of accepting equity financing.
These are some reasons you may prefer equity financing as a source of capital:
The drawbacks of equity financing pertain to the ownership you give your investor:
Before you decide between debt and equity financing, you should ask yourself the following questions:
If you’re the kind of business owner who can’t stand the thought of sharing decision-making authority with someone else, you might see debt financing as your way out. However, if you forecast your budget and determine that you might struggle to repay debt financing, it may be best to play it safe and accept the loss of control that accompanies equity funding.
It can be easy to overlook the impact of interest rates on your debt financing options. Even a small rate change can dramatically increase expenses in a high-interest-rate environment. Interest rates can make or break a new company, especially because it often takes years to achieve profitability as a startup.
Monthly payments on business loans can increase dramatically when interest rates start to rise.
If you need so much capital that you’re already worried about repaying the debt financing for it, equity financing may be a safer bet. However, when you provide equity in return for a large amount of capital, your investors will likely require a proportionately large share of your company. If your investor requests more than 50 percent ownership of your company, your decision-making authority could disappear. This is especially true when you are no longer a startup.
Because equity financing requires you to give ownership shares to your investors, not all business structures can easily explore this funding route. For example, if your company is a partnership, its ownership structure may not be flexible enough to accommodate new shareholders. You can always change your type of business operation, but it’s a lengthy process. [Read more about how to dissolve a partnership agreement.]
Entrepreneurs often assume that equity financing is readily available, but that isn’t always the case. Not all entrepreneurs find investors who are interested in their companies. Other entrepreneurs find investors only after months of searching, so it might not work for you if you need cash fast.
On the other hand, debt financing providers will lend money to virtually any entity that qualifies. If you show a strong credit history, present a convincing business plan and prove that you can repay the loan, you might be in good shape for approval.
Whether you ultimately go with debt financing, equity financing or both, business growth might be quick to follow.
Mike Berner contributed to this article.