Whether you're an early-stage venture looking to fuel its growth or an established cash business looking for emergency capital, there are numerous ways to acquire capital. Today, the two most popular ones are equity financing and debt financing. Both have their own pros/cons and are preferred under different circumstances. Therefore, it is imperative for business owners and startup founders to be educated enough to make the right decision. Below we speak about the differences between the two and discuss various situations where either method may be preferred.
Equity financing typically sounds like an appealing to many tech startup founders with companies that may be months/years away from profitability. Equity financing may also suit founders that are profitable but need funding to significantly expand their reach or develop the next phase of their product. The main questions to consider before going down this road are:
Pros: In many cases, equity financing provides capital for R&D, employee salaries, and anything else a company would need to be successful. Startups that raise a lot of money also tend to get press, which boosts their reputation as well. Furthermore, equity financing puts all the risk on the investors. If the startup were to fail, company founders would not be liable to pay back their investors the money that was lost. Often, big angel investors and venture firms will even act as mentors and provide access to their vast networks for the startups that they fund.
Cons: While this may sound like a "no brainer" for certain startups, there are a myriad of factors that need to be taken into account. Equity financing tends to be a full-time job for young founders and investors that have large amounts of capital tend to be bombarded by hundreds of companies. Since investors take all the risk in equity financing, they may take a sizable portion of a business for their capital contribution. Not only does this mean less future capital for founders should the company be successful and go public or get acquired, but it also means that an outside party now has a say in the company's decisions with an expensive buyout being the only way out.
This method tends to be preferred with companies that already have cash flow and have been in business for at least some time. Companies typically choose this route for shorter-term needs. The main questions to deciding whether this is right for your business depends on the following questions:
Pros: Debt financing is available to almost all businesses regardless of size or industry. It does not require owners to sacrifice any ownership, share profits, or power in company decisions. The money that is received is at the complete disposal of the business with a definite repayment date and amount. A company is not required to send periodic mailings to large numbers of investors, or hold periodic shareholder meetings.
Therefore, if you borrowed $25 thousand at a 10% interest rate and your business gets acquired the following month for $1 million, the lender is only entitled to their principal plus their interest rate. All interest tends to be tax-deductible, and businesses can shop around for the lowest interest rate available.
Cons: Whether your business is successful or fails, repayment is due when it is due. If your business is struggling, it can get very stressful and the debt can act as an anchor to your longevity. Since lenders typically require collateral, businesses that default on loans tend to lose a lot more than the borrowed amount.
Ultimately, both financing methods come with their own benefits and shortcomings. Understanding which is right for you is imperative to the longevity and prosperity of your business. Always make sure to consult with a legal or financial counsel before and do your own research before committing to any path.