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Debt and Equity Financing

The Advantages and Disadvantages of Debt and Equity Financing

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When you decide to start a small business, one of your first questions is likely to be how to raise money to finance your business operations. No matter how you plan to obtain financing for your business, you need to spend some time developing a business plan. Only then should you go forward with financing plans for even a simple small business.

Equity Financing

You may have some cash you want to put into the business yourself, so that will be your initial base. Maybe you also have family or friends who are interested in your business idea and they would like to invest in your business. That may sound good on the surface to you, but even if this is the best arrangement for you, there are factors you must consider before you jump in. If you decide to accept investments from family and friends, you will be using a form of financing called equity financing.

One thing that you want to be clear about is whether your family and friends want to invest in your business or loan you some money for your business. That is a crucial distinction! If they want to invest, then they are offering you equity financing. If they want to loan you money for your business, then that is quite different and is actually considered debt financing.

Advantages of Equity Financing:

  • You can use your cash and that of your investors when you start up your business for all the start-up costs, instead of making large loan payments to banks or other organizations or individuals. You can get underway without the burden of debt on your back.

  • If you have prepared a prospectus for your investors and explained to them that their money is at risk in your brand new start-up business, they will understand that if your business fails, they will not get their money back.

  • Depending on who your investors are, they may offer valuable business assistance that you may not have. This can be important, especially in the early days of a new firm. You may want to consider angel investors or venture capital funding. Choose your investors wisely!

Disadvantages of Equity Financing:

  • Remember that your investors will actually own a piece of your business; how large that piece is depends on how much money they invest. You probably will not want to give up control of your business, so you have to be aware of that when you agree to take on investors. Investors do expect a share of the profits where, if you obtain debt financing, banks or individuals only expect their loans repaid. If you do not make a profit during the first years of your business, then investors don't expect to be paid and you don't have the monkey on your back of paying back loans.

  • Since your investors own a piece of your business, you are expected to act in their best interests as well as your own, or you could open yourself up to a lawsuit. In some cases, if you make your firm's securities available to just a few investors, you may not have to get into a lot of paperwork, but if you open yourself up to wide public trading, the paperwork may overwhelm you. You will need to check with the Securities and Exchange Commission to see the requirements before you make decisions on how widely you want to open up your business for investment.

Debt Financing

If you decide that you do not want to take on investors and want total control of the business yourself, you may want to pursue debt financing in order to start up your business. You will probably try to tap your own sources of funds first by using personal loans, home equity loans, and even credit cards. Perhaps family or friends would be willing to loan you the necessary funds at lower interest rates and better repayment terms. Applying for a business loan is another option.

Advantages of Debt Financing

  • Debt financing allows you to have control of your own destiny regarding your business. You do not have investors or partners to answer to and you can make all the decisions. You own all the profit you make.

  • If you finance your business using debt, the interest you repay on your loan is tax-deductible. This means that it shields part of your business income from taxes and lowers your tax liability every year. Your interest is usually based on the prime interest rate.

  • The lender(s) from whom you borrow money do not share in your profits. All you have to do is make your loan payments in a timely manner.

  • You can apply for a Small Business Administration loan that has more favorable terms for small businesses than traditional commercial bank loans.

Disadvantages of Debt Financing

  • The disadvantages of borrowing money for a small business may be great. You may have large loan payments at precisely the time you need funds for start-up costs. If you don't make loan payments on time to credit cards or commercial banks, you can ruin your credit rating and make borrowing in the future difficult or impossible. If you don't make your loan payments on time to family and friends, you can strain those relationships.

For a new business, commercial banks may require you to pledge your personal assets before they will give you a loan. If your business goes under, you will lose your personal assets.

Any time you use debt financing, you are running the risk of bankruptcy. The more debt financing you use, the higher the risk of bankruptcy. Calculate the debt to equity ratio to determine how much debt your firm is in compared to its equity.

Some will tell you that if you incorporate your business, your personal assets are safe. Don't be so sure of this. Even if you incorporate, most financial institutions will still require a new business to pledge business or personal assets as collateral for your business loans. You can still lose your personal assets.

Which is best; debt or equity financing? It depends on the situation. Your financial capital, potential investors, credit standing, business plan, tax situation, the tax situation of your investors, and the type of business you plan to start all have an impact on that decision. The mix of debt and equity financing that you use will determine your cost of capital for your business.

Two More Traditional Sources of Capital for your Business

Besides debt and equity financing, there are two other traditional sources of capital for your business. Operating revenue and the sale of assets can also generate money for your firm.

Make your financing decisions wisely!

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