When seeking a capital infusion to grow your business, an initial consideration is whether to seek debt or equity financing is essential to positioning yourself for future growth. Below we outline the advantages and disadvantages of each option, and how to determine which is best for you.
Debt: Advantages and Disadvantages
Common types of debt include bank loans, credit cards, and secured lines of credit. When taking on debt financing, one of the most significant benefits is that you retain full ownership and control of your business. In addition, your liability ends immediately once you have repaid your debt in full and the lender has no right to future business profits. On the flip side, your liability will continue until the debt has been satisfied, and you will be required to pay at predictable, regular intervals even in less-than-ideal business conditions. Furthermore, collateral or control rights in the event of default might be included, so a downturn in business and not servicing the debt could have dire results – giving a lender effective control or ownership of the business. But it is ultimately key to seek proper counsel in structuring your debt if, for example, the investors require personal guaranties of principals, a default on the loan can have serious consequences for your personal finances.
Debt, however, can be the simpler way to seek financing, because it is generally perceived as having less risk than equity for the investor (although this isn’t always the case). There are tax benefits to debt financing, as well. The loan interest (which serves as the incentive for the lender) can create a tax deduction for you as the business owner. But an increasing debt-to-equity ratio can negatively impact your company’s valuation and ability to seek additional capital.
Companies best suited to securing debt financing can demonstrate past revenue and a strong likelihood of being able to pay off the debt with future revenue and/or a strong collateral base.
Equity: Advantages and Disadvantages
Equity financing can be an attractive option for businesses by virtue of trading exclusive control for shared risk and reward. Put another way, rather than having a contractual obligation to pay returns by way of interest and repay the loan amount, the equity investor buys ownership in the enterprise and so their returns, or losses, are dictated by the performance of the enterprise. For this reason, equity shareholders have a vested interest in your success, while debt lenders have little stake in it beyond punctual repayment. However, the returns to attract investors can be often higher for equity than what it would potentially cost in interest on debt.
The business experiences little risk if the business fails to succeed and the equity holders have the most to gain if business booms. Companies that seek equity financing can often lose exclusive control over business decisions and businesses as a means for large equity investors to mitigate risk. Another benefit of equity financing is that cash flow can be continually reinvested into the business rather than diverted toward loan payments for debt financing.
What is right for you?
Seeking assistance from a firm like Kaplan Voekler Cunningham & Frank PLC is essential to evaluating options and determining the best fit for your business and your personal risk profile. Key factors to consider are:
- Ownership philosophy
- Risk tolerance for assuming debt
- How much capital you need
- How large you anticipate your business will grow