Debt vs. Equity Financing: What's the Best Choice for Your Business? Credit: Investment image via Shutterstock

In the world of small business financing, there are lenders and there are investors. These two sources of funding can provide you with all the cash you need to start or grow your business. But which is the better option?

Here's a rundown of what debt and equity financing entail, as well as the pros and cons of each method of funding.

Defining debt

Debt financing means borrowing money from an outside source with the promise of paying back the borrowed amount, plus the agreed-upon interest, at a later date.

Traditional secured loans, like those offered by banks, are one form of debt financing. Such loans are typically paid back in monthly installments and require a personal guaranty on the part of the borrower. Inventory, accounts receivable, equipment, real estate and insurance policies can all be used as security on a bank loan. If the borrower can't pay back the loan, this collateral can be used to satisfy payment.

The U.S. Small Business Administration (SBA) also serves as a guarantor for many kinds of small business loans. Because bank loans secured by the SBA are lower-risk than those secured only by a business owner, there are fewer costs associated with taking out such loans. SBA-guaranteed loans typically have longer terms and lower interest rates than alternative-type loans. Business owners approved for an SBA-guaranteed loan also don't have to offer up as much collateral as they might have to when getting a loan from an alternative lender.

But SBA loans aren't for everyone. The lending criteria for such loans can be very stringent, and some business owners — particularly those with less-than-stellar credit histories — may want to look elsewhere when shopping for a loan. Factoring, merchant cash advances, loans from friends and family, and the use of personal or business credit cards are all examples of alternative debt financing options. Unlike traditional loans, some alternative debts — like merchant cash advances— are paid back as a weekly or monthly percentage of a merchant's sales, not as a set monthly payment.

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Why debt works

While some businesses shy away from borrowing money, debt financing certainly has its advantages. For one thing, debt financing can be used to fund just about any kind (or size) of business.

"The SBA offers programs designed to provide access to capital for all types of entrepreneurs," John Fleming, district director of the SBA's Delaware office, said in an email interview with Business News Daily. "We have micro loans, commercial loans up to $5 million and 20-year fix[ed]-rate real estate loans for large projects."

WhileFleming is quick to point out the benefits of choosing an SBA-guaranteed loan to fund small business ventures, small business owners should know that if they choose to go the debt financing route, they'll have many more options than just traditional bank loans. This range of choices is one advantage of using debt financing over equity financing.

While many alternative lenders charge higher interest rates than traditional banks do, they are also more likely to fund business owners whose credit scores are less than perfect or those who don't have sufficient collateral to guaranty a loan.

Another advantage of using debt financing over equity financing is that lenders, unlike investors, don't have any say in how you run your business. With debt financing, business owners enter into a relationship with lenders that ends as soon as the lender has been paid back.

The downside of debt

Loans are by far the most common source of small business funding, but using debt to finance a business does have its drawbacks. For one thing, businesses that are strapped for cash will have to spend a sizable portion of their monthly revenues repaying the money they borrowed from lenders.

"The biggest disadvantage of using debt to finance growth is that debt requires repayment," Steve King, CEO of Alaris Royalty Corp., a Canadian company that offers alternative equity financing to small and medium-size businesses, said in an email interview with Business News Daily.

King, who favors equity financing over debt financing, explained that investing money in your business, rather than in a loan payment, is usually a more profitable option for business owners.

King also pointed out another disadvantage of using debt to fund a business: Debt has to be repaid every month, regardless of how well a business is doing. That means that if your sales take a dip, you may find yourself unable to make your monthly loan payment. This is a drawback that even Fleming, a proponent of debt financing over equity financing, acknowledged.

"Using loans requires monthly payments regardless of revenues generated," Fleming said. "Payment terms are agreed upon up front and are often difficult to change if the business does not perform well."

Equity financing explained

Equity financing, in the world of small business, means raising capital by selling shares of a business to investors. Unlike debt financing, the capital raised through equity financing isn't paid back in monthly installments with interest. Instead, investors put money into a business and become partial owners of that business. They are then entitled to a share of the business's profits over time. Most investors expect a return on their investment within three to five years.

The most common source of equity for small business owners is friends and family. Unlike a personal loan, investments made by friends and family are paid back after your business starts making money, which might not be for several years. Often, business owners will tie payments to investors with the operating cash flow of the business. In other words, when the business is making money, so are investors. Once investors have achieved a specific percentage return on their investments, they are no longer involved in the business.

Friends and family investments are usually made when businesses are just starting out — before entrepreneurs have the ability to obtain debt or equity financing from other sources. But once a business proves its worth, it may be able to obtain financing from angel investors or, in the case of quickly growing startups, venture capitalists.

While angel investors and venture capitalists are often lumped together as one source of funding, they actually serve two distinct functions. Angel investors are individuals who invest their own money (usually between $25,000 and $100,000) into a business, typically during the early startup phase (i.e., before a product or service even goes to market).

Venture capitalists, on the other hand, usually fund businesses in their first stages of growth and are looking to invest a much more substantial amount of money ($7 million or more on average) into burgeoning businesses. Unlike angel capital, venture capital is not private — it's typically controlled by a venture capital firm, not an individual. [See also: 15 Creative Financing Methods for Startups]

The equity advantage

Equity financing isn't for everyone, but it does provide a welcome alternative to debt financing for many business owners. In fact, equity financing cannot be charged with the two biggest gripes business owners level against debt financing: the constraint it places on available cash flow and the risk associated with personally guaranteeing a loan.

"Equity eliminates the disadvantages of debt in that it does not divert capital from the business in order to pay down debt, and it also shares in the business risk along with the entrepreneur," King said.

Another advantage of using equity to fund a business is that you don't have to pay investors back right away. That means you have more time to grow your business before you need to start worrying about how you're going to pay for it all. And, if the business ultimately fails, you won't have anyone to repay. As King pointed out, investors sink or swim alongside the business owners.

Disadvantages of equity financing

Although equity financing is a good option for some kinds of businesses, it also has a downside. 

The biggest disadvantage of using equity to fund a business is that equity investors actually own a percentage of the business in which they invest, Fleming said. Therefore, if the business owner gives up too much of an equity stake (more than 49 percent) in his or her business, he or she can quickly lose control of the business.

This loss of control can be a big problem for business owners who have obtained equity financing but who also want to secure additional debt financing (something a lot of business owners do).

"When applying for debt financing, lenders will often require anyone with at least 20 percent ownership to personally sign for the loan," Fleming said. "Equity investors will usually not sign for additional loans and can block your ability to raise additional capital."

Business owners also have very little control of when an investor decides to exit a business.

"A typical private equity partner requires an exit in five to seven years and will have enough control to force that exit event," King said. "Many times, this exit will not be something that the entrepreneur wants."

But what King sees as an even bigger problem with most equity-financing options is the control investors may have over the day-to-day operations of a business.

"An equity partner can often be influential in the culture and operations of a company, which can have many implications (positive and negative) on a business," said King, whose company offers equity financing with the promise of not taking control of the companies in which it invests.

"Most entrepreneurs would prefer to maintain control of their business and do not want a financial partner telling them how to run their business," he said.

The bottom line

The decision between equity and debt financing will ultimately come down to the kind of business you own.

Fleming said most traditional small businesses, like those in the retail and manufacturing sectors, opt for debt financing to start or build a business. Equity financing, he said, is more suited for business in the technology or innovation sectors, which tend to be higher-risk ventures that offer a bigger return on investment.

King pointed out that businesses looking for equity financing are usually what he calls "high-volatility" businesses, like tech startups or those that belong to deeply cyclical industries, which don't have steady cash flow to make regular loan payments.

Originally published on Business News Daily.