When starting a business or raising capital, the age old question is always brought forward, Loan or Equity Finance? This article aims to answer this question by outlining the different benefits of each as well as its shortcomings. So without further ado let’s break this down!
Loan financing and Equity Financing: An overview
To start, it’s best to first establish an understanding on what the different type of financing actually does for you. One very important point to understand about the two methods is that, equity financing has no repayment obligation while loan or debt financing does not require you to give up a portion of the business ownership.
In simpler terms, loan/debt financing involves borrowing money while equity financing has you selling a portion of equity in the company for a lesser financial burden. With that being said, you can now catch a glimpse of which type of financing is best suited for you. Is it important to maintain control of the business as a principal owner and what would losing control entail?
Of course, we would need to explore both types of financing more in depth before we can form a reasonable conclusion.
Equity Financing:
While it does involve you selling an equity stake in your business to secure the finances, as mentioned above, one key advantage of equity financing is it does not require any repayment in exchange for the initial capital. Most businesses rarely turn a profit within a short period of time, so having that debt-free feeling would leave your mental health in a better state to focus on the business itself.
Why choose equity financing?
Aside from the point mentioned above, another benefit that could be derived from equity financing is that your investors can help run your business alongside you. As they now have a stake in the matter, they will be more inclined to see the business succeed. This also allows you to establish new business connections with them which allows you access to valuable advice and and assistance when required.
Why not equity financing?
With equity financing, a portion of the business profits may go to the shareholders. This means that valuable company profits will not be reinvested into the company. This makes it difficult to rapidly grow the business. You can still choose to negotiate profit distribution with your shareholdeers to reinvest the funds into the business. Not all shareholders may agree with your point of view (which is where many equity arrangements start to fall apart!).
Equity financing also comes with the legal obligation of updating your investors regarding significant business events. Pair this with a lot of regulatory compliance and you may want to think twice before considering equity financing.
Loan Financing:
One of the most common form of financing, loan financing brings with it a lot of advantages. Firstly, as a complete opposite to equity financing, the lender has no control of your business. Once the loan has been repaid, the financier has no ties to your business and you still remain as principal owner.
Why choose loan financing?
Aside from that, a loan also allows you to build trust and relationships with financial institutions. This opens further avenues of business development as you repay loans on time and strengthen confidence. A strong relationship allows for application of bigger loans to finance the business
Why not loan financing?
The biggest downside to getting a loan however is the steady payment that you will have to make consistently. Profits for a business fluctuate and paying off those really large loans would prove problematic. Businesses strapped for cash will have a harder time when faced with loan financing.
Another disadvantage would be putting down your personal property as collateral to secure the loan. Should the business face rough times and does not succeed, you are liable to still make good on those payments for the loan lest the bank sues you. As a general rule of thumb, its not a good idea to secure a business loan against your own home. If things go south, you could end up homeless!
So which to ACTUALLY choose?
With the points stated above, the best answer to the question of whether loan or equity financing is, it depends. The age of your business and its profitability would play a huge factor on what best suits your business needs. There is also the question of your business goals and risk adversity regarding the financing.
Not to mention that not all loans are made equal. This makes weighing out the options become more necessary than ever. Smaller loans generally carry no significant risks while larger sums could have the bank sue you for bankruptcy if you are not able to properly pay off the loan. A rule of thumb to remember is that most businesses start with equity and transition to loans once enough experience is gathered.
Ultimately, the ideal choice depends on what growth stage is your business on. Cash flow needs, risk tolerance and business goals will need to be considered and selecting the financing options that best align with your vision of sustainable growth for your business is key.