Funding your Business with Loans vs. Equity Capital
The two basic types of funding
When it comes to financing a business, there are two basic
types of funding: debt and equity. Loans are debt financing; you borrow money
and must pay it back, with interest, within a certain timeframe. With equity
funding, you raise money by selling a portion of your ownership in the company.
Debt Financing
Common debt financers include banks, finance companies, credit unions, credit
card companies, and private corporations. Taking out a business loan allows you
to remain in the driver's seat of your own company and not answer to investors.
Getting a loan is also usually faster than searching out investors.
Professional investors review thousands of investment opportunities each year,
and only invest in a small fraction.
Another benefit of debt financing is that as you pay down your loan you
build creditworthiness. This makes you more attractive to lenders and increases
your chances of negotiating favorable loan terms in the future.
Overall, debt financing is typically cheaper than equity financing because
you owe only principal, interest and fees, and retain your full ownership
stake in your company.
Equity Financing
Selling equity means taking on investors and being accountable to them. Many
small business owners raise equity by bringing in relatives, friends,
colleagues or customers who hope to see their businesses succeed and get a
return on their investment.
Other sources of equity financing include venture capitalists, which are
professional investors willing to take risks on promising new businesses. These
investors include individuals with substantial net worth, corporations and
financial institutions.
Most investors do not expect an immediate return on investment during the
first phase of your business; they bank on your being profitable in three to
seven years. Equity investors can be passive or active. Passive investors are
willing to give you capital but will play little or no part in running the
company, while active investors expect to be heavily involved in the company's
operations. Personality conflicts can arise in either arrangement. Before you
enter into any agreement with an investor, carefully consider whether or not
you are compatible, as this person will own a portion of your business.
Equity financing is not cheap: your investors are entitled to a
share of your business's profits indefinitely. Conversely, small
business owners who may have difficulty securing a traditional loan or
are comfortable sharing control of their business with partners, may
find equity
financing a mutually beneficial arrangement.