What Is the Difference Between Equity and Debt in Small Business Funding?
Equity Vs. Debt Financing
Equity financing is capital invested into the business. This investment can come from the owner's personal savings, 401(k), friends and family or even professional investors such as angel investors or venture capitalists. Equity financing can be raised at any time in the life of a small business. It is important to note that outside equity investors will own a piece of the business, meaning the owner has ceded some degree of control and autonomy. As owners, the equity investors will share in any profits generated by the business.
It is very unusual for a small business to launch without a meaningful equity investment, as a business funded purely with loans will often find itself cash-strapped due to the need to repay its lenders (with interest, of course). Of course an equity investment can come from the owner in its entirety.
What Are the Pros and Cons of Equity Financing?
Pros / Advantages
- No Monthly Payments. Equity financing doesn't require monthly repayment, allowing a small business owner to reinvest profits into growth (or pocket them)
- Strategic Partners. Ideal outside equity investors have industry expertise or relationships that add value beyond just "cash.".
- Isn't Based on Credit Scores. Creditworthiness is not as much of a consideration for equity investors, allowing small business owners with questionable credit scores or an already large debt burden to access additional capital.
Cons / Disadvantages
- Sharing Ownership. In the case of an outside equity investment, a small business owner is giving up a portion of the ownership to investors that will share in the profits.
- Ceding Control to Outsiders. Outside equity investors will also have a degree of control and influence over the business proportional to their share of the business.
- Lower Return on Investment (ROI). A small business owner's ROI might actually be diminished if the equity to debt ratio is too high. Yes, more debt can be a positive thing under the right circumstances.
Debt financing is capital loaned to the business. Whether a loan from a bank Small Business Administration-backed loan, business credit card or "friends and family" loan, debt financing comes with a commitment to repay the lender, often over specific time period and almost always with interest. Debt financing offers a small business owner greater autonomy than equity financing and allows the owner to keep all of the profits generated by the business.
Along with these attractive benefits comes real risk, as an inability to repay a business debt can be catastrophic, both to the business and the owner. It is wise for small businesses to utilize an optimal mix of debt and equity financing, to strike a healthy balance between the prospect of financial returns and an appropriate cushion for debt repayment.
What Are the Pros and Cons of Debt Financing?
Pros / Advantages
- Maintain Closely-Held Ownership. No need to worry about outsiders taking a piece of the profits or being involved in strategic business decisions.
- Tax-Friendly Capital. There are significant advantages from a tax standpoint to having debt ("the debt tax shield"), reducing tax payments by deducting small business loan interest from a company's income.
- Debt responsibility Shrinks Over Time. Unlike with an equity investment, once a loan is repaid, the small business has more profit to invest in growth or be paid out to the owner.
Cons / Disadvantages
- A Loan is an Obligation That Must Be Repaid. Even when a business experiences choppy waters or a downturn, the lender expects to be repaid. As such, debt can have a direct negative impact on a businesses' viability. Given that many businesses are required to pledge collateral in order to qualify for a loan, non-payment (or default) can result in key business assets being liquidated in order to satisfy a debt.
- The Small Business Owner is Likely on the Hook. In the event the business cannot repay the loan, the lender will often turn to the small business owner or co-signers for repayment.
- Meeting a Lender's Standards Might be Difficult. Lenders are generally very circumspect when it comes to issuing loans. A business owner and the small business itself will be placed under a great deal of scrutiny throughout the application and underwriting process.
- Call Provisions. Some bank loans include provisions which allow the lender to demand repayment of the loan before the end of the term.