Unless you have an existing empire of wealth to build on, chances are good that you’ll need some sort of financing in order to start a business. There are many financing options for small businesses, including bank loans, alternative loans, factoring services, crowdfunding and venture capital.
With this selection, it can be difficult to determine which option is right for you and your business. The first thing to know is that there are two broad categories of financing available to businesses: debt and equity. Figuring out which avenue is right for your business can be confusing, and each option has its own pros and cons. [Read our picks for the best loans for small businesses.]
Here’s an introduction to both debt and equity financing, what they mean, and important things to know before making your decision. [Learn about other alternative financing methods for startups in our guide.]
Many of us are familiar with loans, whether we’ve borrowed money for a mortgage or college tuition. Debt financing a business is much the same. The borrower accepts funds from an outside source and promises to repay the principal plus interest, which represents the “cost” of the money you initially borrowed.
Borrowers will then make monthly payments toward both interest and principal and put up some assets for collateral as reassurance to the lender. Collateral can include inventory, real estate, accounts receivable, insurance policies, or equipment, which will be used as repayment in the event the borrower defaults on the loan.
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The following types of debt financing are the most common:
Like all types of financing, debt financing has both pros and cons. Here are some of the pros:
These are some downsides of debt financing:
[Read Related: Startup Costs: How Much Cash Will You Need?]
Equity financing means selling a stake in your company to investors who hope to share in the future profits of your business. There are several ways to obtain equity financing, such as through a deal with a venture capitalist or equity crowdfunding. Business owners who go this route won’t have to repay in regular installments or deal with steep interest rates. Instead, investors will be partial owners who are entitled to a portion of company profits, perhaps even a voting stake in company decisions depending on the terms of the sale.
These are some common types of equity financing:
[Read our related guide on bootstrapping vs equity funding.]
Angel investors and venture capitalists are often highly experienced, discerning investors who won’t throw money at just any project. To convince an angel or VC to invest, entrepreneurs need a pro forma with solid financials, some semblance of a working product or service, and a qualified management team. Angels and VCs can be difficult to contact if they’re not already in your network, but incubator and accelerator programs often coach startups on how to streamline their operations and get in front of investors, and they may have internal networks to draw from.
“It’s true that equity often doesn’t require any interest payments like in the case of debt,” said Andy Panko, owner and financial planner at Tenon Financial. “[But] the ‘cost’ of equity is typically higher than the cost of debt. Equity holders will still want to get compensated somehow, [which] generally means having to pay dividends and/or ensuring favorable equity price appreciation, which can be difficult to achieve.”
Equity financing is when you receive funding in exchange for shares in your business. Angel investors, venture capitalists and crowdfunding are common types of equity financing.
Similar to debt financing, there are both advantages and disadvantages to using equity financing to raise capital. These are some of the positives:
These are the main cons of equity financing:
Ultimately, the decision between debt and equity financing depends on the type of business you have and whether the advantages outweigh the risks. Do some research on the norms in your industry and what your competitors are doing. Investigate several financial products to see what suits your needs. If you are considering selling equity, do so in a manner that is legal and allows you to retain control over your company.
Many companies use a mix of both types of financing, in which case you can use a formula called the weighted average cost of capital, or WACC, to compare capital structures. The WACC multiplies the percentage costs of debt and equity under a given proposed financing plan by the weight equal to the proportion of total capital represented by each capital type.
Max Freedman, Adam C. Uzialko and Elizabeth Peterson contributed to the writing and research in this article.