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Debt vs. Equity Financing – Which Is Better to Fund Your Small Business?

People love to throw around the cliche “It takes money to make money.” While largely untrue for individual employees, it does contain a ring of truth for entrepreneurs looking to start and grow a business.

After all, real estate, inventory, marketing campaigns, and labor all cost money. Even starting a virtual company costs money in the form of website development, hosting, and other basic operating expenses.

That’s money you don’t necessarily have sitting around in a savings account.

So where do you get money to start a business? While there are many ways to finance a business, most involve either taking on debt or giving up equity.

Financing Your Startup With Debt

You understand how debt works, even if you don’t know every borrowing option available to you.

Make sure you explore all your financing options for business debt before committing to any one option. Beyond the many types of business loans (including SBA loans), you can also take out a personal loan, tap your home equity, or tap personal or business credit cards.

For that matter, you can also borrow money from friends or family members — if you don’t mind risking your relationship on an unproven startup venture.

But keep these pros and cons in mind before signing on the dotted line with any lender, whether bank or brother.


Pros of Debt Financing

Borrowing money to fund your business has plenty of advantages over the alternatives.

1. You Keep 100% of Your Business

When you borrow money, you owe a debt, but you don’t have to give up a percentage of your business.

That keeps your relationship with your financier simple. You owe them a predictable monthly payment for a specified length of time. Once you pay them back in full, you part ways and don’t owe them anything else.

2. You Keep Financial and Managerial Control

Because you keep 100% of your business, no one can tell you how to run it. And for the most part, they can’t tell you how to spend and invest your funding either.

You get to hire who you want, fire who you want, expand how you want, market your goods or services how you want. If you want to pivot to take advantage of a new opportunity in the market, no one stops you.

You stay firmly rooted in the driver’s seat, with no peanut gallery to tell you what to do.

3. Fast and Flexible Funding Options

Theoretically, you could borrow money for your small business within the next five minutes by opening a business credit card or getting automated approval for a loan.

And as outlined above, you have many different options to choose from for borrowing money. You could borrow $200 from a friend or $2 million through an SBA loan, with plenty of other options in between.

4. You Can Deduct the Interest

No one likes paying interest on loans, but deducting the cost of interest on your tax return does take a little sting off of it.

It also reduces the effective cost of borrowing money for your business. If you pay $1,000 in interest over the next year, but you pay taxes at the 24% tax rate and can deduct that $1,000 from your taxable income, then you effectively pay $760 in interest.


Cons of Debt Financing

Of course, debt isn’t exactly something to celebrate. It comes with plenty of drawbacks for entrepreneurs looking to hang their shingles.

1. Cost

You have to pay interest on your debt, and “tax-deductible” doesn’t mean “free.”

Potentially high interest rates aside, regular monthly loan payments also bite into your cash flow. It takes longer to turn a profit when you add to your monthly expenses.

When you borrow money, spend it wisely in ways that actually grow your business.

Too many novice entrepreneurs blow their startup capital on expenses that just don’t improve their bottom line very much, such as bringing in expensive graphic designers to give their logo a flourish or on ritzy office space when they could have kept the company remote-only.

And when it comes time to pay the piper, they pull out empty pockets.

2. You Have to Qualify for a Loan

There isn’t just a magic money ATM that you can walk up to and yank cash from. Someone has to agree to lend you their money, which they only do if they feel confident you’ll, you know, actually pay them back.

Qualifying for a loan is sometimes as simple as asking your dad, but usually, it involves a bank reviewing your credit historybusiness plan, tax returns, and assets. A bad credit score alone can sink your loan hopes, as can any number of other factors.

Get serious about improving your credit and cleaning up your financial statements long before you actually want to borrow money, to boost your odds of success.

3. Consequences of Default

When you fail to pay back a loan, the lender doesn’t typically shrug and say “Oh well, you gave it your best effort!”

Sometimes they secure the loan with specific business assets of yours, such as your inventory or equipment. Most business loans also require a personal guarantee, so lenders can pursue your personal assets, such as your home or car, if you default.

Borrower beware.


Financing Your Company With Equity

Novice entrepreneurs are often less familiar with how equity financing works than debt financing.

With equity financing, the small-business owner typically gives up a percentage of their ownership in exchange for an infusion of capital. The most common examples of equity investors are venture capitalists (think “Shark Tank”) and angel investors, which are similar but not identical.

While venture capital firms tend to be just that — corporate firms — angel investors are often wealthy individuals looking to invest in promising young companies.

For that matter, nowadays you can raise money through crowdfunding platforms for entrepreneurs. Your friends or family members might offer to fund your startup in exchange for an equity stake, either through one of these platforms or less formally.

Keep these pros and cons in mind before signing away a chunk of your business.

Pros of Equity Financing

Despite the daunting idea of giving up part of your business, equity financing comes with its own unique advantages.

1. No Burdensome Debt Payments

As outlined above, monthly debt payments hurt your cash flow and make it harder to turn a profit.

When you raise money by offering an equity stake, you don’t have to make regular payments. Your partners typically plan on getting paid in the future, when you sell your business to a larger competitor or go public via an IPO.

2. Partners Bring Experience and Connections

Your equity partners now have a vested interest in seeing you succeed. Which means they’ll do what they can to help you do so.

Often venture capitalists and angel investors bring a wealth of experience in the same industry. They can help you avoid hurdles and mistakes that bankrupt other companies in your space. Rather than reinventing the wheel all by yourself, you get the collective wisdom and experience of their other successes.

They also typically bring a network of people that can help you succeed. These could be vendors, suppliers, technical teams, contractors, or support services like bookkeeping. They may even connect you with large prospective clients.

The size and quality of your business network often determine your success or failure. Hard stop.

3. Less Recourse If Your Business Fails

Venture capitalists and angel investors don’t typically seize your home if your business fails. They also don’t ruin your credit by reporting to the credit bureaus.

That doesn’t mean they’ll invite you over for dinner parties or ever vouch for you again in the industry. But the consequences of failure are often less dire than if you default on a bank loan.


Cons of Equity Financing

Giving up an equity stake in your company comes with plenty of downsides as well. Make sure you understand them fully before you commit.

1. Loss of Future Profits

If your business does take off and succeed, you don’t get to reap all the rewards. You have to share with your partners.

Unlike the simple borrower-lender relationship, equity partners forge a permanent, complex relationship. You’re stuck with each other until the company sells, goes public, or goes bankrupt, or until one party buys out the other.

You could discover you can’t stand your partner. Or that they don’t bring the wisdom and connections they initially promised.

Or that their “meddling” and company vision directly contradict your own.

2. Loss of Managerial and Financial Control

When you sign away part of your ownership stake, you sign away control of your business. That means you have to discuss every significant business decision with your partner.

They might see the company’s future quite differently than you do, desire to expand into a different market than you do, or wish to remain in your current market when you see more opportunities elsewhere.

Likewise, they may want to invest resources differently than you do. They want to put most of your shared capital into one marketing strategy, while you want to invest money in another way.

You’re married now, for richer or poorer, for better or worse.

3. Slow Initial Fundraising

It could take months for a venture capital firm to greenlight you for equity funding.

You need to prepare a pitch deck, your business plan, and detailed financials and projections, and go through a full dog-and-pony show just to present your case for why they should consider investing and partnering with you.

By contrast, business loans often move much faster — although not necessarily, particularly with all the red tape involved in an SBA loan.


Should I Finance My Company with Debt or Equity?

As you explore all your options, ask yourself a few key questions. The answers will help you determine exactly how to go about raising money for your company.

These questions revolve around the following criteria:

Speed and Urgency

How fast do you want (or need) the money?

If you need it quickly, you probably don’t have time to woo equity investors. They follow their own procedures at their own pace, and they get turned off by the smell of desperation.

Explore loans to move faster.

Fundraising Amount

How much money do you want or need?

The less money you need, the more likely you are to be able to borrow it and avoid giving up part of your company’s ownership. An entrepreneur who only needs $10,000 can probably raise it from a credit card if all else fails, whereas someone who needs $5 million has fewer options.

Appeal of Expertise and Connections

Do you just want cash, or do you also want experienced mentors and a broad network of connections?

If you just want money, a loan can meet your needs. But if you want to hit the ground running with the support of experts in your industry and a wide range of connections, it’s often worth giving up a share of your company to secure them.

Openness to Sharing

Do you mind sharing ownership of your business, or do you want to retain 100% financial, managerial, and creative control over it?

Some entrepreneurs would sooner sever a limb than give up control of their baby. Others would rather bring in as much outside expertise as possible in the hopes of growing quickly.

And, for that matter, some people just don’t play well with others. Know yourself well enough to choose wisely.

Long-Term Goal

What’s your long-term goal for the business, and your exit strategy?

For all the complexity that the talking heads bring to this question, there are really only two models for success in business.

The first aims to cash out as soon as possible. You grow your business as fast as you can, with the goal of either selling it to a larger fish in the pond or holding an IPO.

The other model is a lifestyle business: a company with low expenses, low stress, and high revenue that you continue to work for many years because you enjoy it and it earns you a strong income. It could be a sole proprietorship, where you work by yourself, or it could be a local or online business with a relatively small team.

These entrepreneurs don’t pursue growth for growth’s sake, but only to the extent that it generates more profit, rather than simply adding higher revenue with equally higher complexity and costs. Their exit strategy involves passing the business to their child or selling it to someone they like when they retire.

Entrepreneurs aiming to cash out fast should consider raising money through both equity and debt. But entrepreneurs looking to build a lifestyle business should use debt — or fund their business through savings.


A Third Option: Your Own Savings and Income

My business partner and I financed our own company with savings. But not, as it turned out, the way we had originally imagined.

In the beginning, we had some seed money set aside in a savings account. It was enough money to see us to profitability, we thought at first.

Then our web developer ran off with half our seed money. Then another partner went out of business and left us with no ready replacement. And on and on the crises went, which is how startups often go.

At a certain point we each picked up a side hustle to generate some income while we continued building our business. My partner dusted off her real estate agent license. I picked up freelance writing. We both asked our (unhappy) spouses to live as leanly as possible, maximizing our savings rates so we could pump as much money as possible into our business.

And at a certain point, we turned a profit.

Alternatively, you could start a business on the side while working a full-time job. Regardless of what you consider your “main gig” versus your “side gig,” you continue earning money to help keep you and your business afloat financially until you turn enough of a profit to quit.

Which you may never do. My partner and I have both continued working our side gigs long after our company became profitable, for the simple reason that we enjoy it. And it helps our spouses sleep at night knowing we each have an income floor.


Final Word

Starting a business is the hardest thing I’ve ever done. Harder than moving overseas and making all new friends in my late 30s, harder than raising a child, harder than my goal of reaching financial independence within five years of being broke.

It’s been absolutely, positively worth it.

I’ve never felt more engaged with my work. It has forced me to grow as a person in unexpected ways and has opened surprising doors and opportunities for me.

Despite my original background in rental investing, for example, I actually invest my money today in ways I never would have discovered if I hadn’t started a business rather than continuing to clock in for someone else every day.

If you feel that starting a business is not just your best option, but your only option for a fulfilling life, I wish you good fortune. Now you just need to find a way to pay for it.

G. Brian Davis
G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.

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