Every new business must find funding from somewhere. In many cases, an entrepreneur will have money of their own, or money from family and friends, to invest in a business. This is known as equity financing. If this is not possible then the only realistic alternative is debt financing in the form of loans from financial institutions. Here, we compare the two and examine some of the advantages and disadvantages of each.
It is a big choice for any business person looking to set up or expand a company ? will they borrow the money the need or look for investors? If they borrow money they will have to make sure they can keep up with repayments, and they need to be willing to face high interest charges.
However, equity financing often means the business person gives up some control in the business, and they'll have to answer to and provide a return to investors. Also, equity financing has a much different effect on cash flow, earnings and taxes than debt financing.
Put simply, debt financing is the borrowing of money to keep a business running, to expand a business, or to acquire assets. Long term debt financing is usually associated with larger assets such as machinery, equipment or real estate, and it is paid back over many years. Short term debt financing on the other hand is most often used for business operations such as supplies or payroll and is often paid back within a year. Longer term debt financing comes in the form of term-loans, where the term of the loan and the interest rate is agreed with the lender.
Equity offers an entirely different funding option for a business. Normally, equity financing is provided in exchange for an interest in the business. Also, equity investors can ask for dividends or a share of the annual profits. There may also be an issue of the length of the investment. An investor may want to opt out at some point in the future which could force the sale of the business or require the owner to find replacement investment.
It is ideal if the business owner can provide equity financing from their own personal funds. This means they retain full control of the business, and they do not have to answer to outside investors. However, this is often not possible and equity financing most commonly comes from friends and family. For larger incorporated companies, investors would receive shares in the company, but most commonly they receive a share of the businesses? ownership.
Although there is no restriction on how equity funding is spent, it is usually for start up or the long term running of a business. Day-to-day costs, payroll and other running costs are usually provided through debt financing.
Choosing between debt and equity financing is a fundamental choice for any business, and it is important that both avenues are well researched and the necessary preparations are made.
Before getting started a business person should take care of a few basic preparations. They should gather the company?s financial records like income statements and balance sheets. It's also a good idea to gather paperwork relating to your own personal finances and the company?s assets as these may be needed if you opt for debt financing. Also, it is worthwhile to calculate how much the business could afford to devote to debt repayments every month. Consider hiring a lawyer to look at the terms of the strategy you choose and to help correct any incorrect negative information relating to your personal or business finances.
It is a good idea to speak with all potential investors to see how willing they would be to provide equity financing and what kind of returns they would expect.
Making the Choice
Flexibility is often key in any successful business venture, and the same applies when it comes to choosing financing options. Most businesses use both debt and equity to varying degrees, depending on their particular situation. Too much debt can lead to problems keeping up with repayments to financial institutions, while too much equity can result in the loss of control of the company.
In the end, both debt and equity financing provide an often essential means of funding a business. The right one for a particular business will depend on a number of factors including the size, financial situation, product etc. of the business. There is no clear winner in the debt v equity question, the right choice will depend on circumstances.
If you'd like to speak with a lender about debt financing, take a moment to fill out a short form, and one of SimplyFinance's representatives will contact you to introduce you to a lender that will be able to answer any questions you may have before they search the market for the best debt financing deal available based on your particular need.