The Difference Between Debt and Equity Financing:-Unless you’re Kylie Jenner and have an existing empire of wealth to build on, chances are good that you’ll need some sort of financing in order to start a business.
Even entrepreneurs who bootstrap their companies often need credit cards to urge things going. Difference Between Debt and Equity Financing.
There are many financing options for small businesses, including bank loans, alternative loans, factoring services, crowdfunding, and venture capital.
With this selection, it can be difficult to determine which option is right for you and your business.
The first thing to know is that there are two broad categories of financing available to businesses: debt and equity. Figuring out which avenue is right for your business can be confusing, and each option has its own set of pros and cons.
Here’s an introduction to both debt and equity financing, what they mean, and important things to understand before making your decision. Unique Business Ideas to Inspire You in 2020
What is debt financing?
Many of us are familiar with loans, whether you’ve borrowed money for a mortgage or for college tuition. Debt financing a business is much the same.
The borrower accepts funds from an outside source and promises to repay the principal plus interest, which represents the “cost” of the money you initially borrowed.
Borrowers will then make monthly payments toward both interest and principal, and put up some assets for collateral as reassurance to the lender.
Collateral can include inventory, real estate, accounts receivable, insurance policies or equipment, which will be used as repayment in the event the borrower defaults on the loan. Difference Between Cash and Profit
Debt financing includes traditional loans from banks. The Small Business Administration is a popular choice for business owners.
The SBA offers loans through banking partners with lower interest rates and longer terms, but there are stricter requirements for approval. The Difference Between Debt and Equity Financing.
Alternatives to business loans include merchant cash advances, personal lines of credit and business credit cards.
With some of the alternative financing methods, borrowers may be required to make weekly payments or repay a percentage of their profits, rather than make fixed monthly payments.
Pros and cons of debt financing
Debt financing is widely available in one form or another for many small business owners. it’s a well-liked avenue for businesses because the terms are often clear and finite, and owners retain full control of their operations, unlike in an equity financing arrangement.
However, repayment and interest terms can be steep. Borrowers typically begin making payments the first month after the loan has funded, which can be challenging for a startup because the business isn’t on firm financial footing yet. Related: 10 Great business ideas for 2019
Another disadvantage of debt financing is the potential for personal financial losses if it becomes impossible to repay the loan.
Whether a business owner is risking their personal credit score, personal property or previous investments in their business, it can be devastating to default on a loan and may result in bankruptcy.
What is equity financing?
Equity financing means selling a stake in your company to investors who hope to share within the future profits of your business.
There are several ways to obtain equity financing, such as through a deal with a venture capitalist or equity crowdfunding.
Business owners who go this route won’t need to repay in regular installments or affect steep interest rates. Instead, investors are going to be partial owners who are entitled to some of the company profits, maybe even a voting stake in company decisions counting on the terms of the sale.
Angel investors and venture capitalists are two types of equity investors that are often on the lookout for startups with the potential to grow rapidly but require a capital investment to do so.
These are often highly experienced, discerning investors who won’t throw money at just any project. Angel investors are high net worth individuals who often have some sort of relationship with the business founder, while venture capitalists are seasoned private investors who seek out promising startups. 8 Small Business Ideas for Entrepreneurs
To convince an angel or VC to invest, entrepreneurs need a pro forma with solid financials, some semblance of a working product or service, and a qualified management team. Angels and VCs can be difficult to contact if they’re not already in your network, but incubator and accelerator programs often coach startups on how to streamline their operations and get in front of investors, and they may have internal networks to draw from. The Difference Between Debt and Equity Financing.Related: Business Ideas for Creative Artists
Another version of equity financing, known as equity crowdfunding, allows businesses to sell very small shares of the company to many investors via crowdfunding platforms.
These campaigns usually require immense marketing efforts and a great deal of groundwork to hit the intended goal and be funded. Title III of the JOBS Act lays out the specifics of equity crowdfunding.
Pros and cons of equity financing
Unlike debt financing, equity financing is tough to return by for many businesses. This type of funding is well suited for startups in high-growth industries, such as the technology sector, and requires a strong personal network, an attractive business plan, and the foundation to back it all up.
However, companies that score investments will have capital on hand to scale up and will not be required to start paying it back (with interest) until the business is profitable. Launching Your Business in 2020? What You Need to Know
Equity financing allows the business owner to distribute financial risk among a larger group of people. When you aren’t making a profit, you don’t have to make repayments. If the business fails, none of the money needs to be repaid.
Business owners should, however, be careful when selling shares of the company. If you relinquish more than 49% of your business, even to separate investors, you will lose your majority stake in the company.
That means less control over company operations and therefore the risk of removal from a management position if the opposite shareholders plan to change leadership. The Difference Between Debt and Equity Financing. 12 Business Ideas with (Almost) No Startup Costs
Equity holders will still want to get compensated somehow, [which] generally means having to pay dividends and/or ensuring favorable equity price appreciation, which can be difficult to achieve.”
How to choose between debt and equity financing
Ultimately, the choice between debt and equity financing depends on the sort of business you’ve got and whether the benefits outweigh the risks.
Do some research on the norms in your industry and what your competitors do. Investigate several financial products to ascertain what suits your needs. If you’re considering selling equity, do so during a manner that’s legal and allows you to retain control over your company. 10 Things to Do Before Opening a Restaurant
Many companies use a mixture of both sorts of financing, during which case you’ll use a formula called the weighted monetary value of capital, or WACC, to match capital structures.
The WACC multiplies the share costs of debt and equity under a given proposed financing plan by the load adequate to the proportion of total capital represented by each capital type.