Debt vs. Equity: The Age-Old Business Funding Debate
There is a constant debate over the use of the two main types of business loans and which is more useful. In reality, they both have their uses, and rather than arguing over the merits of each, organizations would be well to use a blend of both at appropriate moments during their growth. Small, or new business owners may not fully understand what the differences are, and some, new to the business financing realm may not even know what equity financing is.
The term equity is bandied about in personal loans regarding the value of assets vs. outstanding loan amounts placed on it, and equity is acquired much the same way in businesses. However, equity lending is not done on a personal level so understanding how the equity can be used to fund a business is something all newcomers should understand.
The Two Sides of a Coin
Debt lending is the side of business financing that almost everyone is familiar with. It is a straightforward loan that works much the same for businesses as it does for personal loans. It is a fixed amount of money “mortgaged” on the firm or other variable assets that are set to play out over time and are subject to an interest structure for repayment.
Debt lending has numerous characteristics that make it an appealing kind of business finance, the first of which is the all-important credit buildup for good payback performance. The downside of debt financing is that it requires repayment that can take away from a business’s profits, usually requires collateral in the form of business assets, or personal assets to secure the loan, and perhaps the most difficult aspect of debt financing of all: debt lenders are notoriously conservative. It is up to the business owner to prove the value of their company, their ability to repay a loan, and the financial prospects of their company.
Another positive value of a debt loan vs. an equity loan is that the interest paid on a debt loan is tax-deductible. Perhaps an even bigger incentive to choose a debt loan is that debt loans offer lenders no control over the way the business is run.
Equity loans are far less understood by many business owners. These loans can be made by both private investors and banks, yet there are no payment arrangements or interest charges because you don’t have to pay them back! Whoa, before you go dancing off to your local financial institution to plunk down a request for equity financing here’s the catch: Equity financing is an exchange of financing in exchange for a piece of your company. You are selling off part of the value of your company.
This is essentially the same as taking on a partner; while some finance is provided without actual control, you will be paying an equal amount of your future business profits to your new “partner.”
Whether equity financing comes with an active or silent partner many business owners are reluctant to sell off part of their future profits. Another downside is that since there are no “payments” as in debt financing there is nothing to deduct on your business’s tax filings.
Another factor to consider is that equity funding, also known as venture capital, is typically only granted if a company can demonstrate the ability to employ the funds to generate exponential growth, resulting in a high return on investment for the lender.
Which Type of Financing to Choose
In some cases, obtaining equity funding can be challenging. New businesses usually neither have the equity built up, nor the track record to judge a business’ performance to obtain such a loan. That, however, is also a problem for new businesses when applying for a standard debt loan. Chances are, if you have a strong business plan, good concept, and any equity value at all in the form of inventory, building, or equipment you can find private investors that might be easier to obtain than bank debt financing.
Equity finance companies are also more competitive and aggressive. They can take more chances because the potential for payoffs is greater. With debt financing, the return on investment is a set figure—no less, no more than the original contract. With equity financing, if the business really takes off the financer stands to reap great rewards.
One argument is that debt financing, if available, provides the best security for business owners, with less possible loss over time and no loss of control over firm direction or operation. It would seem that it is the best choice in all situations, and yet businesses big and small who understand both forms of financing well know that there are times when equity financing simply makes more sense.
If you do not have enough profit to repay a debt loan, equity financing makes good sense. It can provide you with the means to develop or adopt new procedures to maximize your earning potential, after which you can apply for a more traditional sort of loan. Startups with a strong business model stand to benefit the most from equity investment. They very often cannot afford to repay a debt loan, but will in the foreseeable future have massive profits.
Established businesses that find themselves stagnated and in need of a boost of cash to expand may not be in a position to pay monthly payments on a debt loan either. They may also find banks even more reluctant to lend money on the chance they will improve than they are willing to finance a startup. In such instances, an equity loan is ideal.
When a company, regardless of its size, is capable of acquiring and maintaining debt loan payments, it should pursue that sort of funding. Even venture capitalists will avoid a company that never grows to the point where it can afford to take on debt. Companies that are constantly expanding and on the verge of bankruptcy will appear to be dangerous on either side of the coin, therefore it is critical to have long periods of time where the business is operating at a healthy profit margin before attempting to obtain additional loans of any kind.
Each businessman will have their own opinions about the ideal balance of debt and equity financing. Businesses that maximize the benefits of both are well on their way to a prosperous future. Instead of considering debt against equity financing, business owners should consider debt AND equity financing for a stable future.