Debt or equity financing: which one to choose?
Debt and equity are two tools you can use to finance, operate and grow your business. Each has its pros and cons and it’s important to understand these differences before deciding which tool can best help you grow your business.
Let’s start with fairness. Equity financing requires you to sell some of your business equity in exchange for capital to fund your business. A major advantage of equity financing is that you can obtain this financing before you have the sales in hand. This makes it an attractive option for funding a prototype or starting from scratch.
Equity financing often pays a bigger check than debt financing because the financial partners want to reap the rewards of a successful business and are willing to contribute to that growth.
However, equity financing has drawbacks. While it may seem attractive to secure a large investment without the need for sales in hand or a repayment plan, equity financing does not come free.
Equity financing is more expensive than most people realize because a percentage of all future profits and sales will be permanently forfeited. The equity partnership is a long-term commitment, which will not end once you earn a certain amount.
There is also a possible loss of control to consider. You may have to give up a seat on the board, for example, and future decisions will have to be made with your private equity partner in mind.
James Bartel, of Sallyport Commercial Finance, also points out that equity financing can be difficult to obtain and put a strain on your business. “Private equity firms are driven by huge profits and believe that only one in ten investments – or less – will pay off, while most entrepreneurs don’t think they need stick growth of hockey to succeed.” Additionally, Bartel cautions that it’s a lot of work to pitch to a private equity firm. It takes more time, more money and more effort than debt financing.
Debt financing involves borrowing money and paying it back, plus interest. There are some negatives to keep in mind when considering debt financing. For one thing, most debts require a personal guarantee, although this is only applicable if the business goes bankrupt and there are no assets left in the business to repay the debt. In addition, debt financing often has some type of requirement or covenant, such as debt service coverage.
You may encounter obstacles with debt financing depending on where you are in developing your business. “Debt cannot be used to finance an idea, nor be disproportionate to collateral,” Bartel says. If your only collateral is your elevator pitch, debt financing is probably not for you.
But debt financing has obvious advantages. One of the main advantages is that debt financing does not require you to give up ownership of your business, which means that the loss of control is minimal. And without a private equity partner looking for quick gratification, debt can allow companies to grow rationally.
There are also fixed fees with debt financing and no additional fees for advice from a lender. Additionally, debt financing is possible for almost any type of business, as there are many different types of lenders.
Sallyport, for example, is a lender that does not require covenants. They have some flexibility with warranties, offering limited and validity warranties. They can also handle unique situations, such as foreign or government accounts receivable, milestone billing, non-dilutive financing, and non-bank loans when bank financing is only partially available or not available at all.
So how do you know what’s right for you? Think about the type of business you want to finance and your needs. Bartel suggests the following guidelines.
Equity financing is a good choice for:
– pre-revenue companies
– companies with massive research and development
Debt financing is a good choice for:
– more established companies (especially for bank debt)
– companies needing to fill out purchase orders
– companies that have declined business due to lack of liquidity or cash flow
– seasonal or cyclical businesses and businesses that have growth needs based on sales rather than future sales
Debt and equity are useful in different situations. It’s important to explore your options, know the true cost of equity, and use debt when possible or when it makes sense for your business. For for more on debt financing versus equity financing, see Veristrat.