Choosing Between Debt and Equity Financing

There are different types of financing that an entrepreneur can choose from in order
to fund a new business. All such options are categorized, accordingly, into two
groups: debt financing and equity financing, both of which have benefits and disadvantages
for the entrepreneur.

When choosing debt financing for a new business, entrepreneurs are simply acquiring
a loan from a lending institution or government agency, such as the Small Business
Administration. When they decide to choose equity financing to fund their venture,
they are simply exchanging the amount of capital for a piece of ownership in the
business. The latter type of financing is usually provided by venture capitalists
and angel investors.

Debt financing refers to any borrowed money which the entrepreneur
must pay back to the lending institution. It can come in the form of a loan, line
of credit, bond, or even an IOU. An interest rate and other terms apply.

Equity financing is money lent in exchange for ownership in a company.

New businesses
can use equity financing for their startups or when they need to
raise additional equity capital to offset existing debt.

Who depends on this type of capital?

• Companies which are well- established and have demonstrated steady sales,
solid collateral, and profitable growth often rely on debt capital for financing
their businesses.

• Companies with a more conventional approach to management, high profitability,
and/or poor credit ratings often rely on equity capital for their funding needs.

• Ideal form of capital for small business startups and newly launched companies
since they have not established a solid track record of success and face uncertainty
in their early stages of development.

Where can I obtain this type of funding?

• Commercial banks
• Loans through the Small Business Administration (SBA)

• Personal funds (bootstrap finances) can be obtained from savings, credit
cards, retirement accounts, property equity, etc.
• Friends and family can lend money for a stake in the company.
•
Angel investors
and venture capitalists can also provide a new business owner
with desired capital in exchange for a board seat, a stake in the company, and large
return on investment.
• Investment banking firms
• Insurance companies
• Large corporations
• Government-backed Small Business Investment Corporations (SBICs)

Debt-to-equity ratio

High (ideally, 1:2 or 1:1, depends on industry)

Low

Requirements

• Exceptional credit history of borrower.
• Borrowers must show potential lenders they are willing to invest money in
the business by using their own money.

• Good-standing credit history
• Borrowers must demonstrate their company is in a high-growth industry and
there is a potential to produce a large return on investment.
• Well-detailed business plan and clear exit strategy.

Advantages

• Lender does not gain ownership; therefore, the entrepreneur is able to maintain
maximum control over their business.

• The borrower has no obligation to the lender other than the repayment of
the loan; their relationship ends once the entire amount is paid back.

• The interest on debt financing is tax deductible.

• Depending on the terms of the loan, repayment of the loan is often a fixed,
monthly expense.

The business will not have all of its cash flow available to do business

• Allows the entrepreneur to obtain funds without incurring debt = more cash
flow. This will allow business owners to focus their attention on making their product(s)
profitable rather than paying back the investors.
• Enables the investor(s) and business owner(s) the opportunity to develop
a long term relationship throughout their joint business endeavor.
• The cash flow generated can be used for follow-on investments rather than
towards the loan debt.
• Capital borrowed from family and friends is a quick way to raise capital
with no overbearing interest rates.

Disadvantages

• Requires regular monthly payments with steadily accrued interest = limited
cash flow.

• Tarnished credit ratings can result from the inability to pay back any borrowed
capital, limiting the chances of raising additional capital.

• Often limited to established businesses with a solid track record of success.

• Dilution of ownership can easily occur; the more investors involved, the
more loss of control.
• Angel investors or venture capitalists may feel inclined to have a say in
every business decision.

• If capital was obtained from bootstrap finances, credit cards may be maxed
out. If money was borrowed from family and friends, then relationship strains may
occur.

• Too much equity can suggest that entrepreneurs are not making use of their
borrowed funds; whereas too little may demonstrate non-commitment on the company
owners’ part.
• Complex reporting is often required by investors.

Application process

• A formal application must be filled out either in person at the lending institution
of choice or online.

An application and other pertinent materials are required for angel investors and
venture capitalists. Family and friends usually do not require an application process.

Credit check

Yes. The higher the credit score of the company owner(s), the better the chance
in obtaining a loan.

• Angel investors and venture capitalists will usually conduct a credit check
of the business owners during the due diligence process but may rely more on the
potential of return on investment.
• Family and friends usually do not conduct a credit check.

Term options

• Short-term debt financing: total repayment of borrowed capital in less than
one year.
• Long-term: total repayment of borrowed capital in over one year.

Usually, both angel investors and venture capitalists are involved in an investment
for an average of 3-7 years.

Other

• A type of long-term debt financing payment is a balloon payment,
whereby the end of the term the lender and borrower negotiate a new loan amount
for the residual amount left.

• Variable rates usually occur with long-term debt financing,
where the interest rates are adjustable by the lender according to market performance.

• Companies can also opt to obtain equity financing by selling company stock
to employees, Employee Stock Ownership Plan (ESOP), sharing control
of the company with them rather than with outside investors.

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