Financing a Small Business: Debt vs. Equity (2024)
Lisa Moyers, Fountain City office manager, Pinnacle Financial Partners
On average, entrepreneurs need about $65,000 to start a business, two-thirds of which comes from personal savings, according to Babson College in Wellesley, Mass. To account for the other third, owners typically can choose between two types of financing: debt or equity.
Which one you decide to pursue will depend on a number of factors, such as your industry, purpose for financing and amount of control you want to retain over your business. Each has its advantages and disadvantages, so understanding which would be a better fit is a good step as you get your business off the ground or move it to the next stage of growth.
Debt financing Debt can be a loan, line of credit or bond. It may be a good option as long as you plan to have sufficient cash flow to pay back the principal and interest. The major advantage of debt financing over equity is that you retain full ownership of your business. Plus, interest payments are deductible business expenses, and you’ll build your credit. Because most debt entails scheduled payments, it’s easy to plan around.
But there are some disadvantages. Financing with debt can be more expensive. And those scheduled payments have to be made on time, regardless of your cash flow.
You will need to have a good personal and business credit history to receive debt financing, particularly in the current economic conditions. Lenders generally require a history of cash flow generation or sufficient collateral. Personal guarantees are common on most debt instruments. You should also not have a significant amount of debt already on the books.
Equity financing You may want to consider equity financing if you have concerns about qualifying for a loan or channeling too much of your profits into the repayment plan. Investors and partners that provide equity financing expect to make a return on their investment, but you aren’t obligated to pay back equity contributors if you don’t turn a profit. No debt payments mean more cash at your disposal.
A disadvantage is that once you have other financial contributors (who each expect a share), you are no longer the full owner of your business. You’ll give up some financial, creative and strategic control.
Equity financing can come from friends, family, colleagues or professional venture capitalists. Angel investors are the largest source of seed and start-up capital for businesses. They tend to fund small businesses for longer periods of time and expect a lower return on investment than venture capital firms. Funding from angel investors amounted to $9.1 billion in the first half of 2009, according to University of New Hampshire's Center for Venture Research.
Creating a mix Debt and equity capital can work together. Most businesses have a mix of both. How much of each you have will depend on your business. You can check with your industry association to find the average debt-to-equity ratio for your peers or seek advice from your financial advisor.
You can reach Lisa Moyers at 865-766-3052 or by e-mail atlisa.moyers@pnfp.com.
Debt financing occurs when a company raises money by selling debt instruments to investors. Debt financing is the opposite of equity financing, which entails issuing stock to raise money. Debt financing occurs when a firm sells fixed income products, such as bonds, bills, or notes.
involves the borrowing of money whereas equity financing involves selling a portion of equity in the company. The main advantage of equity financing is that there is no obligation to repay the money acquired through it.
Debt financing can offer the means to grow without diluting ownership, while equity financing can provide valuable resources and partnerships without the pressure of repayment schedules. Remember, the best choice is one that aligns with your startup's unique circ*mstances and future aspirations.
Since Debt is almost always cheaper than Equity, Debt is almost always the answer. Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders' expected returns are lower than those of equity investors (shareholders). The risk and potential returns of Debt are both lower.
It may be a good option as long as you plan to have sufficient cash flow to pay back the principal and interest. The major advantage of debt financing over equity is that you retain full ownership of your business. Plus, interest payments are deductible business expenses, and you'll build your credit.
Equity financing is essential to new companies just starting out. But once you have some equity as a startup, leveraging debt financing makes sense. Use both debt and equity together to create an optimal capital structure and make your company more financially stable as you grow.
Debt financing can be riskier if you are not profitable as there will be loan pressure from your lenders. However, equity financing can be risky if your investors expect you to turn a healthy profit, which they often do. If they are unhappy, they could try and negotiate for cheaper equity or divest altogether.
Equity Financing also has some disadvantages as compared to other methods of raising capital, including: The company gives up a portion of ownership. Leaders may be forced to consult with investors when making a decision. Equity typically costs more than debt financing due to higher risk.
Pros of debt financing include immediate access to capital, interest payments may be tax-deductible, no dilution of ownership. Cons of debt financing include the obligation to repay with interest, potential for financial strain, risk of default.
Pecking Order Theory suggests a hierarchical order in which businesses utilize three types of financing: internal funds, debt, and equity to fund investment opportunities. To fund operations, companies first utilize internal funds, such as earnings. If these funds are low, companies turn to debt, such as loans.
If your business debt exceeds 30 percent of your business capital, this is another signal you're carrying too much debt. The best accounting software can help you track your business debt, manage your cash flow, and better understand your business' financial situation.
An ideal debt-to-income ratio is somewhere around 40%, but the exact number changes on an individual basis. There are some warning signs, however, that can indicate that your business is carrying too much debt: You have many past-due bills. You miss payments, or wait to pay certain bills.
Small businesses typically use debt or equity financing — or a combination of the two. Debt financing involves borrowing money from a third party, which you then repay, with interest. Equity financing, on the other hand, means you receive money from an investor in exchange for partial ownership of your company.
The optimal D/E ratio varies by industry, but it should not be above a level of 2.0. A D/E ratio of 2 indicates the company derives two-thirds of its capital financing from debt and one-third from shareholder equity.
Equity should be used for financing when the risk of not being able to service debt (payment of principal and interest) is high. If you can't repay, don't borrow! The greater the business risk makes equity the better choice for financing. This is the reason why start-ups are typically financed with equity.
A business that is overly dependent on debt could be seen as 'high risk' by potential investors, and that could limit access to equity financing at some point. Collateral. By agreeing to provide collateral to the lender, you could put some business assets at potential risk.
One advantage of debt financing is that it allows a business to leverage a small amount of money into a much larger sum, enabling more rapid growth than might otherwise be possible. Another advantage is that the payments on the debt are generally tax-deductible.
Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company's profit margins. Equity capital may come in the following forms: Common Stock: Companies sell common stock to shareholders to raise cash.
The Cost of Equity is generally higher than the Cost of Debt since equity investors take on more risk when purchasing a company's stock as opposed to a company's bond.
Introduction: My name is Kimberely Baumbach CPA, I am a gorgeous, bright, charming, encouraging, zealous, lively, good person who loves writing and wants to share my knowledge and understanding with you.
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