You are ready to start your own business, but you don’t know where to look for financing. You are curious about loans and have heard about equity, but this is not your area of expertise. You are not alone. One of the toughest decisions small business owners face is how to obtain financing for their business.
Most business owners really have two options: take out a loan or sell part of their business to start making money. Go ahead to explore the different options that may be available to you.
Choose between loans and equity
While there are no hard and fast rules, if you are in the formation stage of your business, it makes sense to seriously consider selling an equity stake in your business in order to secure funding to get it up and running. Stock sales are advantageous because they do not require any repayment, and most businesses do not make a profit for a significant period of time, making late loan repayments extremely difficult.
If you are an established business and have ongoing financing needs, then borrowing can make a lot more sense. Loans are easier to handle when a company has enough cash flow to make the payment realistic, and an established company probably has more collateral to offer to secure the loans. Lastly, it’s worth noting that loans and equity are treated differently for tax purposes, so check with a business tax advisor to see if one course of action makes more sense than the other.
Whether you should choose loans or not depends largely on the maturity of your business, cash flow and whether you are simply not willing to give up any other control in your business.
- Advantage: The biggest advantage to choosing loans is that you maintain control over your business. Unlike equity investors, lenders have no say in your business and are not entitled to profits from your business. The only obligation you owe to your lender is to repay the loan as agreed. Finally, one last advantage that can be very useful is that loan payments that go toward paying interest on the loan can be deducted as a business expense for tax purposes.
- Disadvantages: The biggest downside to loans is that you have to pay a fixed amount on a consistent schedule, and, as anyone who runs a business knows, earnings can be anything but stable. You may have to make a large loan payment precisely when you need the cash for your business the most. Another downside is that many small business owners have to use their personal property as collateral to secure the loan, putting them at personal risk if the business goes bad. Finally, if you are unable to repay the loan, you may be personally sued by the bank, regardless of whether the loan is guaranteed or not.
Equity is a mixed set of benefits and costs, and factors that influence whether you decide to use equity sales to finance your business include whether your business is still young or expanding and your willingness to give people control of the business. you are not yourself.
- AdvantageAlthough many may view giving other people an interest in your business as losing control, this does not have to be the case. If you choose the right investors, they can be of great help in running the business, establishing business connections, and offering valuable advice and assistance. Another advantage of equity investments over loans is that they tend to be much more creative and flexible, which many companies may prefer. The biggest advantage of selling equity stakes to investors is that if your business loses money or goes bankrupt, you probably won’t have to pay investors a penny.
- DisadvantagesLoss of control in your business is probably the biggest disadvantage involved in selling stocks to finance your business. There are many cases in which the founders of a company, who have invested years of their life in the company, are expelled by the investors. Be very careful to really consider whether the financial gain is worth the loss of control. The other main disadvantage is that equity investors will want to receive a portion of the profits from the business, taking away valuable business profits that could otherwise be reinvested in the business. Finally, because equity investors are now co-owners, you have a duty to inform them of all major business events, and they can now sue you if they feel their rights are being violated.
Capital investments vs. loans
Knowing the differences between obtaining a loan and attracting a private equity investor is essential in choosing which one is the most suitable for you.
Small businesses looking for capital basically have two options: finding business loans or securing equity investments. Determining which one is best for your business will depend on the type of business you own, your creditworthiness, and your willingness to have someone look over your proverbial shoulder.
Advantages of business loans
- You maintain complete ownership of your business and remain the only voice in the running of your business.
- The lender does not receive any portion of your earnings or say in the business.
- Managing your finances for loan repayments is easier than posting earnings with an equity investor. With a loan, you will have regular monthly payments for a fixed period.
- Interest payments can be deducted as business expenses.
- You can use the money from a business loan in any way you see fit.
- If you need it, paying off a loan is a great motivator to work extremely hard to make your business successful.
Disadvantages of business loans
- You have to pay interest on the loan, so you will have to pay more than what you have borrowed.
- If you have bad credit, you may not be able to get a loan.
- You may have to provide collateral on personal property in order to secure the loan.
- Even if the loan is not secured by personal property, if you default on the loan, the lender may personally sue you.
- If the business fails, you still have to repay the loan in full, plus interest.
Advantages of equity investments
- Investors may be better suited to provide large amounts of capital. Banks are wary of very large loans due to the risk of default.
- The repayment terms are more flexible than those of commercial loans.
- Depending on the investor, you may have an integrated network of business mentors and advisers to help your business.
- Because they have equity in the business, you have people who are interested in the business being successful and will help you in this goal.
- If the business fails, you usually don’t have to pay the investors (failing fraud, of course).
Disadvantages of equity investments
- You may lose total control over the direction or day-to-day operations of your business. Investors may want to sit on the board of directors and oversee operations.
- Venture capitalists typically invest in businesses that have the potential to offer a huge return on their investments (i.e. software companies, scientific inventions) and are generally not interested in most small businesses that do not anticipate great growth potential. .
- You may have to share a larger portion of your earnings with equity investors.
- Investors retain legal rights regarding the management of the business and have the right to sue you if these rights are violated.
Venture Capitalists and Angel Investors
Many people hear the term venture capitalists and assume that these investors will be interested in becoming equity investors in their business. However, venture capitalists are like any major investor and are looking for a great return on their investment. Therefore, venture capitalists are not interested in most small businesses, which are generally looking to make enough profit to make a comfortable living for the owner and employees. Unless your business projects huge potential profits (for example, you have a restaurant that you think has franchise potential, or you have an invention you’re working on that needs research and development capital), forget about venture capitalists.
What you may be looking for is an “angel” investor. Angel investors (the name comes from an old term that describes investors in Broadway productions) also seek a return on their investment, but their investment objective is sometimes more altruistic. They are often wealthy entrepreneurs who want to share their knowledge and help companies get off the ground.
The information on angel investors is not as detailed as surveys of venture capitalists or traditional lenders, and it is often difficult to tell the difference between a regular business investor and an angel investor (an angel investor could also be a member of the family or friend), but according to the Small Business Administration, they are out there, and they are investing in the success of many small businesses.
Selection between business loans and equity investments
Ultimately, you will have to determine how the advantages and disadvantages of a business loan and equity investment apply to you and your business. If your business plan projects potentially large growth, equity investors may be attractive for their lenient payment terms, low risk (they won’t sue you unless you defraud them), and business acumen.
On the other hand, if you project modest growth (that is, if you are not planning to run a large company) or if you want complete autonomy in making business decisions, a loan might be better for you.
Whichever option you choose, be sure to carefully consider the pros and cons of a loan or equity investment, and you can make a well-thought-out decision.