By Hassan Kitenda,CAIA
Starting your own business can be a direful but gratifying process. While designing a great business plan is critical for founders, financing is one of the most important elements a company needs to succeed. Financing is needed to start a business and ramp it up to profitability. If you want to start a business, you will need a certain amount of initial capital. However, financing a startup can be a difficult, gathering funding is a challenge that almost all business owners face at some point. Financing can come in two forms debt financing or equity financing. Should you take out a business loan or look for an investor? Figuring out how to finance your business is a crucial decision that can have big consequences. So, which is more suitable for your startup debt or equity?
What is debt financing? Essentially, it involves the borrowing of money and paying it back with interest. Often, you will have to repay in monthly installments, over a fixed period of time. I know we are all familiar with debt, if you’ve ever taken out a loan, you’ve financed something with debt.
So, why debt financing?
You get to keep your baby, the biggest and most obvious advantage of using debt is control and ownership. With traditional types of debt financing you are not giving up any controlling interests in your business. It’s all yours. You get to make all the decisions and no one is going to kick you out of your own company.
Retaining profits, when you opt for equity financing, the stakes you give your investor entitle them to a portion of your profits. With debt financing, your profits remain entirely yours.
Businesses using debt financing to raise capital have more flexibility than those using equity financing because they are only obligated to the investor or lender for the repayment period. After all money is paid back, the business is completely free from its obligation. Companies also have greater flexibility because the paperwork to obtain debt financing is less complicated and less expensive than equity financing.
So, what are the downsides of debt financing?
The business is obligated to pay back the principal borrowed along with interest. Businesses suffering from cash flow problems may have a difficult time repaying the money.
Lenders will typically demand that certain assets of the company be held as collateral, and the owner is often required to guarantee the loan personally.
If you fail to repay the loan, your business’s assets could get seized by the lender.
What is equity financing?
Equity financing refers to the sale of company shares in order to raise capital. Investors who purchase the shares are also purchasing ownership rights to the company. This may be in the form of close partnerships, or equity fundraising from angel investors, crowdfunding platforms, venture capital firms, and eventually the public in the form of an IPO.
Why would you choose equity financing?
The main advantage of equity financing is that there is no obligation to repay the money acquired through it, furthermore you don’t have to pay interest on the capital you raise, so there’s no need to put your business’s profits into debt repayments. This means you’ve got more cash available to grow your business.
There are no fixed repayments to be made. Instead, your equity investors receive a percentage of the profits, according to their stock.
Far more important than the money is that bringing in equity partners means bringing in others with a vested interest in seeing you succeed. If they have influence, connections and experience, that can make all the difference in becoming the next unicorn success story, versus languishing as a small business for decades.
What are the downsides of equity financing?
The main disadvantage of equity financing is that company owners must give up a portion of their ownership and dilute their control. You’ll have to consult with investors, and you might disagree over the direction of your company. You might even be forced to cash out and abandon your own business.
A reduced ownership percentage can also not only mean that you have to split the profits, but in some cases, some investors may be entitled to any positive returns before you can get a penny.
It takes a long time especially when compared to some of the fastest debt financing options out there.
Finally, the decision between debt and equity financing depends on the type of business you have and whether the advantages offset the risks. Understand which may be the most beneficial for your current stage of business and how it could help or hurt for future fundraising needs.
Mr Hassan Kitenda is an equity and fixed income analyst.
Email: [email protected].