Business loan vs. Equity Financing: Which one is the best for you?

An Overview of Business loan and Equity Financing:

If a business owner needs finance, you usually have two options: debt or equity financing. Debt financing entails borrowing money from a third party and promising to repay it with interest on a future date. Someone putting money or assets into a business in exchange for a portion of ownership is called equity financing.

Companies typically have the option of seeking debt or equity financing. The decision is frequently influenced by which source of capital is most conveniently accessible to the firm, its cash flow, and how vital it is to the company’s significant shareholders to preserve control of the company. The debt-to-equity ratio shows the amount of a company’s funding that is provided by debt and equity.

Debt financing entails borrowing money, whereas equity financing entails selling a piece of the company’s shares. The primary benefit of equity financing is that there is no responsibility to repay the funds obtained. As a result, the corporation incurs no additional financial strain from equity financing, yet, the negative can be significant. The fundamental advantage of debt financing is that the business owner does not relinquish ownership of the company, as with equity financing.

What is a Business loan?

Debt financing means borrowing some amount of money and repaying the same with an interest rate. Debt finance may impose constraints on the company’s actions, preventing it from capitalizing on opportunities outside of its primary business. 

There are various advantages to debt finance. First and foremost, the lender has no authority over your company. When you are done repaying the debt, your association with the financier comes to an end. The rate of interest you will pay is tax deductible. 

Loans also allow you to use the money for nearly any reason. There are a number of loans that are customized according to a particular need of your organization.

However, there are some important points that each and every borrower should take care of. In virtually all circumstances, you would make monthly installments, and a missed payment might be a severe financial blunder. In any incidence of default, the bank might seize your assets.

What is Equity Financing:

Equity finance means selling a share from the company’s equity in exchange for a certain amount of funds. For example, Company X’s owner needs to raise a certain amount of funds to fund corporate expansion. The owner decides to sell 10% of the company’s stock to an investor in exchange for capital. That investor now has a share of 10% in the company and can become part of all future decisions. 

The foremost advantage of equity financing is that there is no obligation or necessity to repay the number of funds obtained. Of course, the owners of the company want it to succeed in delivering a high return on investments for the equity investors without doing any necessary payments or interest rates, such as debt financing.

The corporation bears no additional financial burden as a result of equity financing. Additionally, as there are no monthly bill payments with equity financing, the company will have more capital to invest in business expansion and growth. However, equity financing still has risks. 

In fact, the disadvantage is pretty significant. You will have to split your profits and confer with your new partners whenever you make business decisions. The only method to get rid of the equity investors is to buy them out, which will certainly cost much more than the amount of money they gave you while fundraising.

Equity financing is appropriate for organizations in the growth stage as well as those with few or no physical assets. In such circumstances, investors wager on the expansion of the company and believe in getting profit from their investment at a later period. In addition, equity financing is attractive since there is no immediate obligation to repay the funds raised.

A few points to consider before choosing any one option:

Both methods provide cash, but each has advantages and disadvantages. Debt financing can be costly, particularly if you have poor credit. At the same time, equity financing necessitates giving up a stake in your firm and allowing investors to have a say in business choices. Every business owner should answer two primary questions before going for debt or equity financing. 

Immediate need for funding or not:

You will save a lot of time with debt financing, and you will get the money soon, most probably between a matter of a few days to a few weeks. Short-term finance is revolving and is utilized for inventory or material expenditures. 

Long-term business loans are classified or identified as an installment and are often used to fund machinery, equipment, or start-up costs. The parameters of debt financing are transparent and laid forth at the outset. 

Equity financing takes longer. Business owners and investors will negotiate the investment package, which includes what percentage stake will be offered in exchange for cash, and much time will be spent debating the business’s future value. 

If you are working with a number of investors, competing for perspectives on what that value ultimately will complicate matters and require more time for negotiation. Furthermore, equity financing requires far more legal work, making it the more time-consuming option.

If you want full control of your business or you are ready to diversify the controlling power to the investors:

You can keep control of your company if you use debt financing. Lenders do not want a part of your company; they only want to know that you will repay the amount. The disadvantage of debt financing is that you are saddled with the expense of a loan and making a monthly payment with interest, but it may be the preferable alternative if you are unwilling to give up a percentage of “your baby.” 

You will give up some of the control of your company in exchange for equity investment. Moreover, according to the terms and conditions of the agreement, your investors will give up controlling the majority of your company, which simply means they can vote you out of the start-up or company that was your brainchild. 

However, if stock or equity financing is the major difference between your firm’s success and failure, it’s worth giving up a certain degree of control. Furthermore, with equity financing, you are giving up power and future worth, which must be considered. Giving away 10% of a $100,000 firm seems significantly less significant than giving up the same amount of $10,000,000.

Consider business loans when:

You are eligible and qualified for the same: Obtaining a company loan is only sometimes simple, especially for start-ups needing capital. Lenders will then more frequently want a particular amount of time in business, stable credit, stable financials, and a certain form of collateral. You might be able to get the desired rate of interest.

You want to increase cash flow: Obtaining a company loan is not always simple, especially for start-ups in need of capital. Lenders want an exact amount of time in business, suitable credit, stable financials, and a certain kind of collateral. If you meet those requirements, you can obtain a competitive interest rate.

You are expecting to increase your money: For example, if you borrow $200,000 at an 8% annual percentage rate but expect a 15% return, debt financing may be worthwhile. Another advantage is that debt repayment can help your company’s credit score, which can lead to future rates and rates of return.

Consider Equity Financing when:

You have no issues in giving a stake in your company:

An investor with a big enough stake is entitled to voting rights and can demand acts such as the election of new directors. You may have forgotten about your company if your final wager is over 50 percent of your ownership. To reclaim it, you’d have to buy out investors, which may be costly.

You do not want any debt:

Because there is no loan to repay or collateral at stake, equity financing may be less risky than debt financing. Debt also necessitates monthly repayments, which can have a negative impact on your company’s cash flow and ability to grow.

Your company is at a very early stage:

If you are not to qualify for a beginning business loan and wish to avoid more expensive options such as credit cards, equity financing may be required. Because your company is new, be sure the investment is reasonable.

Final Verdict:

Many organizations in the starting stage will seek equity funding. However, those people are well established, and they don’t have any problem with debt financing, and a solid and strong credit score may look for typical debt financing.