One of the most daunting tasks of an entrepreneur is how you go about raising capital, whether you are starting or expanding your business.
Debt often gets a bad reputation due to hidden fees, high rates, or horror stories of over borrowing. Equity meanwhile is scary because you are inviting outside ownership into your business. There is no right or wrong answer when choosing debt or equity, but you should know the benefits and drawbacks of each when entering the financing arena.
At Able, we believe in choosing what aligns with the entrepreneur’s ultimate vision for the business.
Equity is a less common form of financing for business, yet the perception is that equity will make your business destined to succeed. News headlines amplify this sentiment that equity should be celebrated. Can it pay off? Absolutely. And full disclosure is that Able is backed by some savvy outside investors. But does it make sense for every small business?
For those familiar with Shark Tank, equity financing works similar to what you’ve seen on the show. Investors and partners will provide capital to you because they are confident in the earnings potential of your business. In return, they get a stake in your company. Equity investors could be friends and family, angel investors, or venture capital firms.
In general, there are three big "pros" to equity:
- No structured payments: You are only obligated to pay your investors once your company starts making money with equity, which frees up additional money that your business may not have otherwise. Then when your business starts to generate profit, the amount your investors receive is dependent on their percent of ownership in your business.
- A sounding board: With equity financing, most strategic decisions are vetted by investors. You’ll have an additional set of minds to help navigate and guide your venture, but you’ll also lose having full control of your business.
- Greater dollar amounts: Because it doesn't need to be repaid on a fixed schedule, equity makes sense if you need to raise a lot of funds or your business has a wide moat it needs to cross in order to be successful. This is needed in industries with potential exponential growth, and high upfront costs, like a technology startup.
Likewise, there are significant downsides to equity, as well:
- Transaction time and cost: Raising equity is slow and costly. In fact, in our experience, equity is probably the slowest and most expensive form of capital raise (and we do a lot of fundraising as part of our business). Terms need to be negotiated, diligence needs to be done, investors have to be satisfied, documents need to be drafted and executed, and lawyers need to substantiate their fees by quibbling about everything.
- The "permanent high interest rate": When you sell a portion of your company, you're taking on a "permanent high interest rate" in the form of shareholder dividends. As your company grows, so does the interest rate. Likewise, because the value of an equity stake is tied to the value of the company, as the company grows, so too does the buyout price for shareholders. In short, equity financing is a bit of a gamble in that you are trading the future upside of your business for financing now.
- Losing full ownership: With equity, you are giving up some of your business. New owners, even minority owners, will have substantial rights to control/influence the direction of your business... either directly or indirectly through consents and/or veto powers. Due to reporting requirements, you may also need to do an "open kimono" more than you'd like.
- Being in a partnership: Having equity ownership means that you now have two groups to please: your customers and your investors. This can sometimes create unfavorable tensions (either between investors and management or between investors and investors). It can also contribute to a lack of focus, as the company gets pulled in 2-3 different directions trying to keep everyone happy.
Debt is the most common form of financing and can be used by businesses of all size. It is ironic that debt is less costly for the majority of businesses, but rarely does debt get the ‘credit’ it deserves (as this article points out).
Debt financing involves borrowing money from a third party, usually from a bank or alternative lender, and a promise to return the principal and interest.
There are many advantages to debt that favor small businesses when planned out thoughtfully. On a high level, here are some of the biggest benefits to debt:
- Retain control: Debt allows you to retain the most flexibility to execute the business decisions you want. Lenders have some control over the decisions you make in the form of loan covenants, but typically far less than investors.
- Retain profits: Assuming all is going well, lenders are not entitled to your profits — their main concern is that you make repayments on time.
- Debt goes away. Unlike equity, debt goes away. There's no "permanent high interest rate." Make your payments on time and at the end of the term, you don't owe anything more.
- Build your business credit: Taking on a business loan will build your business credit, which will beneficial if you choose to borrow more capital in the future. The future lenders can see that your prior debt was well-managed, which gives you an advantage for lower interest rates.
- Tax deductions: In most cases, the interest you pay on loans is tax deductible as a business expense.
- Forces financial discipline: Debt payments are an expense that you have to pay every month. Successful business owners learn the discipline needed in order to pay off this debt and keep the business profitable. Their discipline is rewarded when they pay off the debt (and can now roll those monthly payments back into the business) without sacrificing any ownership stake.
When to Use Which
The bottom line question most entrepreneurs have is when to use debt as opposed to equity.
This question deserves its own blog post (and has one!). But the short answer is you should use debt when it's affordable and the return on the debt is greater than the cost of the debt. If that's not the case, you should raise equity (or re-think your plan, as the case may be).