Does it really matter how you secure the funds for your business? The short, straight-forward answer is “Yes”. The more detailed and more convincing answer is “Yes, because the money comes at a cost. Because if you don’t choose the right option, you may never recover from this cost”.
So, what all options do you have? Excluding bootstrapping, which won’t get you too far, you mainly have two options: get a loan from a bank (debt financing) or get an investor (equity financing). Understanding the difference between the two is what can make all the difference.
So, let’s figure out what debt and equity financing are before we discuss how to choose what’s best for your business.
You have money that you have been saving for a long time for your business. You decide to use all that to start up your venture. Since it’s your own money, you have complete control over where you invest it and when you invest it. This also means that you own 100% equity in your business.
Imagine you meet a couple of friends who are impressed by the performance of your business and are willing to invest an amount equal to the value of your investment. You like the idea and accept the money. Now, you don’t have to pay any interest on that money or return the money, but your equity is now divided among three people. Your ownership is 50% and the rest half is owned by your friends. This arrangement is equity financing. As you bring more and more investors on board, your equity in the business will keep diluting.
Things You Need to Know About Equity Financing
- Equity financing not just dilutes your ownership but also your ability to take business decisions independently. This means that you no longer enjoy complete control over where and when you invest the money.
- In case you lose the money, you are not obligated to return the money to your investors. Therefore, it’s comparatively a less risky way of financing. Either everyone gains or no one – it’s that simple.
If you are willing to take on the risk alone and don’t want to dilute your ownership as well as decision-making power, debt financing is the option. Debt financing is when you borrow money from someone with a promise to pay back over a certain period of time with interest. This usually includes getting a personal loan, a business loan, or a line of credit.
Depending on what type of loan you are applying for, you may have to pledge an asset as collateral for the loan. In that case, if you fail to repay the loan, the lender can choose to recover the dues by selling your asset.
Things You Need to Know About Debt Financing
- No matter what type of loan you take, you will have complete control over your business. You are paying interest to the lender for using their money, so you get the right to use it whichever way you like.
- Whether or not you make profit, you will have to repay the money to the lender. Else, you might end up losing your assets.
- The interest rate on your loan will be based on not just your credit score but also the financial performance of your business in the past.
Choosing the Right Option for Your Business
So, you know that the money comes at a cost and it’s not just the financial cost. There are other costs involved too, like the decision-making power. Pretty much why it’s important that you make a careful choice for your business. Check out some things you need to consider to know which option is right for your business.
Your Capital Requirement
If the capital you need for your business isn’t too big, go for debt financing. Either apply for a loan or a line of credit, which you can easily repay in monthly instalments with interest.
Only if your requirement is huge, you should consider equity financing. In that case, you could get in touch with venture capitalists or angel investors who are always looking out for businesses with potential. If you can convince them about the potential of your business, you could raise a big amount.
Short-Term vs Long-Term Requirement
If you need funds for a short period of time, may be to fulfil a business order, debt financing would be the best option. But, if you want to go big and have a long-term plan in mind, it’s best to look for an investor who believes in your idea and shares your appetite for growth.
Your Willingness to Give Up Your Ownership
Equity financing leads of dilution of ownership. So, if you are not willing to give up a share of your ownership, that is completely fine and that means you should consider debt financing. However, if you are willing to dilute your equity in return for cash and experience that an angel investor will bring, then equity financing could be a great option.
Expected Cash Flow from Operations
If it’s a startup and you are not expecting to generate enough cash flow to service the debt, then consider equity financing. With debt financing, you have to pay the interest and principal amount, regardless of the performance of your business. On the contrary, if you are confident about the revenue and cash flow, you can look at debt financing as an option.
Choosing the right financing option is important. The future of your business depends on it. Make your choice carefully after considering all the factors mentioned above in mind.