Financing Your Small Business: Debt Vs Equity

As an aspiring or practising Small Business Owner, you will need money to start or grow your small business. In realising this objective, one question you must continually wrestle with is whether you should get a loan or get an investor.

There are many unspoken concerns that lie beneath this question, which seeks to tilt the balance between debt financing and equity financing. At the centre of this tussle are how quickly the business can access money, the process through which a loan may be obtained, the bureaucratic and legal paperwork that may be required, the cost of using the money, and the risks to be borne by the business, the lender and/or the investor.

For a new business, debt finance offers a viable option of raising cash. It entails getting credit in the name of the business. While it remains a challenge for a start-up to get a loan advance, there is a good chance of success because the process is fairly straightforward. The starting point is for the business to present its financial statements in the form of a bankable business plan, preferably prepared with the assistance or approval of an experienced financial adviser.

The catch here is that it could take weeks or months to obtain approval for a business loan. The lender may also require the business or its promoters to have a skin in the game, by requiring either or both of them to stake some of their own money or provide an acceptable collateral to secure the loan. There may also be the need for owners of the business to co-sign the loan through personal guarantees.

In return for the loan granted to it, the business is obliged to repay the principal loan amount, plus interest at an agreed rate. The percentage rate depends on such factors as the lender, history of the business, its credit rating and that of its owners, especially if it is a new business.

For the business, the risk is that if it fails to service the credit, the lender will be forced to call in the loan, and possibly force the business into bankruptcy. For the owners of the business, the lender may be constrained to lean on their personal guarantees where the assets of the business are not sufficient to liquidate the debt.

In spite of the obstacles and risks of obtaining debt finance, it might still be easier (or advisable) to get a business loan, instead of funding from investors.

The lender has near zero control of the business and may simply require regular and periodic financial statements to ensure that the business is performing according to projections. This leaves the Small Business Owner with control of the day-to-day running of the business.

Not so when the Small Business Owner takes in investors. In receiving money from iinvestors, whether from family, friends or venture capitalists, the Small Business Owner must enter into agreement with the investor(s), and spell out what to expect from each and every party. In addition to that, with equity funding, the Small Business Owner must give up full control of the operations of the business. The other shareholders will be given seats on the board of directors and will be watching over the business to protect their investments and be sure that it succeeds.

While it is easier to get family and friends as investors, it is not that easy to get venture capitalists to sign on. However, they all understand that, unlike a lender, they will not get their money back if the business fails to turn a profit, or closes shop.

The bottom line is that, as a Small Business Owner searching for money to start or grow your business, you must appreciate the likely trade-off in the choice between debt financing and equity finance. Would you rather take the expensive route of getting a loan, paying interest rate, staking some of your own money, risking foreclosure and keeping control of the business? Or take the cheaper option, in the short run, of getting investors to share your risk of failure (and loss of their money), sharing control of the business and, in case of success, perpetually receiving a piece of pie from the business in the form of dividend payments?

If you are thinking of starting or growing your business, you must decide whether to get a business loan or get investor equity. The former might just be your better bet for raising investable cash.

Contact Us Now if you are pondering about borrowing money to invest in a business opportunity. Or drop me a note at ted.iwere@smefinance.org, so we can share ideas on when to, and when not to, borrow to invest.

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