Definition – Debt
Debt: Debt financing involves borrowing money for your business, usually from a bank in the form of a loan. This is the most common way for small businesses to get financing, because banks are more interested in smaller, lower risk investment opportunities. The main benefit to choosing debt financing (as opposed to equity) is that you will retain ownership of all of your business, which gives you the freedom to continue to run your business as you see fit without having to answer to an investor who may not have the same values that you do.
Definition – Equity
Equity: Equity involves raising money by selling a portion of ownership in your company. Instead of profiting collecting interest payments on a loan, an equity investor makes a return on his or her investment when the company is sold. The most common types of equity investors are Angel Investors and Venture Capital firms.
The main downside of debt financing is the reality that the money you are loaned has to be paid back, with interest, and you may have to collateralize the loan with assets, or personally guarantee that the loan will be repaid. Obviously this takes a bite out of your company’s profits, which can make it more difficult to grow because cash that you would otherwise invest into growth strategies must be used to make payments on your loan. Moreover, loans are usually paid back according to a pre-determined schedule, which does not necessarily account for the peaks and valleys that are likely to occur in your revenue stream. On the bright side, your interest payments are tax deductible, which can make the burden of interest payments easier to manage.
Equity funding can be more attractive to a business because they are not required to pay the investor back. Not having debt means more cash on hand to grow your company, and if no profit materializes, you aren’t obligated to pay back equity contributions.
The major downside of an equity investment is that you are no longer own your business exclusively, as your investor takes a share of ownership in exchange for his or her investment. As a consequence, you will be giving up not just financial control, but you will have to share control of your business’s creative and strategic direction. However, this can also be a benefit. If you are an inexperienced entrepreneur or are in a risky field, the advice and leadership from a knowledgeable investor may be useful.
Overall, your company’s options for funding are based on how well your needs and qualifications match up with what your investor is looking for in an investment. As a business owner, your goal should be to find the funding sources that will allow you to execute your business strategy as easily as possible, without taking on more debt or giving up more equity than you need to. There are several varieties of both debt and equity financing, each of which has its own set of pros and cons, and many companies use both debt and equity financing. Therefore, it is important to seek out several alternatives and choose the best available options for the specific needs of your company.
Also note that Angel Investors, wealthy individuals or groups that are looking to fund businesses as an investment, tend to invest for a longer period of time and also don’t expect as large of a return as VC’s do. Venture Capital Firms, on the other hand, expect returns within five years.