Equity vs. Debt: Which is Better for Your Business?

For business owners, the decision to finance a company via debt or equity can be a crucial choice for the direction and future of the company. Both options have their pros and cons, so it’s important to carefully weigh the benefits and downfalls of each and determine how it will impact your business and personal life before signing on the dotted line.

Equity Investment

Equity investment is when a business raises money by selling interests in the company. Investors, who could be as close to you as friends or family or as removed as angel investors or venture capitalists, take a percentage of your company when they agree to fund the business.

With equity financing, the investor is on the hook for the majority of the risk. If your business fails, you do not have to pay the investor back the money that was invested in the company. No out-of-pocket payments mean that you will also have more cash on hand to invest in the business upfront. This can be a huge relief for start-ups or small businesses that are just starting to turn profits and gain market leverage.

However, the downside of equity financing is enough of many small business owners to shy away from this option. Understandably, investors in your company will share your profits and benefit from your successes. As the owner of the company, you will reap a smaller portion of the rewards for your hard work, a hard pill to swallow when the time comes to pay your investors.

In addition to giving up some of your future profits, you’re also giving up some of your control of the company when you bring on investors. Before making decisions that will affect your business, you’ll need to consult with your shareholders and keep them abreast of company actions.

Debt

Just like taking out a loan for a car or a mortgage for a home, taking on debt for a business involves borrowing money to be repaid to a lender, plus interest. Businesses may be eligible for an SBA-backed loan, a private loan, a line of credit from a bank, or a personal loan from friends or family.

Unlike with equity financing, the lender in a debt financing arrangement has no control over your business. Once the loan is paid in full, your relationship with the lender is over. A lender is only entitled to the agreed-upon principal plus interest of the loan, not any future profits of the company.

Other advantages of debt are that interest paid on the debt is tax deductible, and that the regularity of loan payments makes them easy to forecast and plan for out of monthly cash flow in comparison to fluctuating investor payments.

The disadvantages of debt financing are likely well known to any business owner who also has personal debt. Loan payments must be paid back on time, or the consequences can be severe for your business. By taking on debt, you are taking the risk that your company will be able to comfortable and confidently pay back the loan. Many business owners find themselves in a situation where loan payments hamper their ability to grow or stretch their funds too thin.

Although you won’t need to give up control of your company with debt financing, you will need to pledge certain assets of the company as collateral. And, even if the company is registered as an LLC or another type of business entity, lenders may still require you to personally guarantee the loan with your personal financial assets.

Which Option Is Best For You?

For many business owners, equity financing can be more difficult to obtain. Investors are hard to come by for businesses that don’t have a large reach or a proven record of sales. I don’t think this is necessarily a bad thing.

Some of you may know my take on the show “Shark Tank,” a TV Show in which hopeful entrepreneurs pitch their business ideas to a group of investors with the hope of making an equity financing deal. I think the show has a tendency to glamorize the world of equity investing and make it seem like a reality for all small businesses. The show would be vastly improved if there were a lender in the group alongside the investors to present a different option for financing.

In my opinion, debt financing can be a great solution for small businesses in a variety of different situations – starting a business, expanding a business, weathering a financial storm or investing in sales or marketing. With the right education, the right loan product and a clear path to pay back the loan, debt financing can often be the best option for small business.