Whether you are seeking startup or growth capital for your business, there are two basic types of financing you can obtain: debt and equity. The type of financing that’s right for you will depend on a variety of factors. Here’s a closer look at the differences between debt and equity financing and how to determine which is best for your small business.
Debt financing usually takes the form of a loan. This loan might come from a bank, a commercial finance company, or a friend or relative. Using business credit cards or obtaining a business line of credit are other forms of debt financing. What all types of debt financing have in common is you have to pay them back, usually with interest.
In equity financing, someone invests money in your business in return for a percentage of ownership. Equity financing may come from a private or “angel” investor, a friend or family member, or by selling shares in your business to investors. There are also institutional forms of equity financing, such as venture capital. Venture capital funds aggregate and manage money from wealthy investors, then invest it in fast-growing businesses.
Which form of financing is best for your business, debt or equity?
In general, taking on debt financing is almost always a better move than giving away equity in your business. By giving away equity, you are giving up some—possibly all—control of your company. You’re also complicating future decision-making by involving investors. Taking on debt, in contrast, is a relatively short-term move that leaves you in control of the business (as long as you are able to pay back the debt).
However, the right solution for you when considering debt vs. equity financing may vary depending on your current needs and future plans. Here are some common situations in which you might consider debt vs. equity financing.
Debt financing is typically the way to go for smaller amounts of capital. Even angel investors rarely make investments under $100,000, and venture capitalists will only consider investments in the millions of dollars. If you need, say, $10,000 or $25,000, you will need to look into debt financing.
Giving up equity in your business is a big decision, and you shouldn’t do it in return for financing that solves a short-term problem. If you are having a temporary cash crunch or need financing for the next year’s growth plans, look into a short-term financing solution that you can pay once you get “over the hump.”
If you truly expect your business to be the next Uber/Facebook/Starbucks and have the business plan, financial projections and other hard data to convince sophisticated investors you can do it, then it may be worth taking a shot at venture capital financing. You’ll need a strong management team, the ability to “sell” your concept and a business plan that will generate a big return on the investors’ capital within a short time frame—typically three to five years.
Do you need a mid-range amount of capital (such as $100,000 to $1 million) and want expert guidance in addition to the money? Equity investment through an angel investor could be the way to go. Angels are often experienced (or retired) business owners seeking to invest in industries where they have expertise. Many of them are willing to be actively involved in mentoring and guiding the business owners they invest in.
Need money in a hurry? Getting debt financing is a much faster process than finding equity capital, which involves identifying and pitching to investors, then drawing up legal documents and other paperwork regarding the equity. In contrast, online debt financing solutions can get you funded in a matter of days.