Entrepreneurs are usually torn on debt and equity financing. There’s no one right choice. Instead, you should consider a number of factors.
There are benefits to both: Giving up equity to investors typically results in more money to grow the business than you’d ever get from a lender, but debt allows you to retain control. That makes it tough to decide which route to pursue. Consider these factors.
Availability
Debt: If your company has been in business for less than three years, has no record of regular profitability or has a negative net worth, most banks won’t take your call. Other options are out there, including the SBA and nontraditional, high-interest-rate lenders.
Equity: Finding equity investors can be a long process with an uncertain outcome. You could spend months searching for funding in vain.
Winner: It’s a draw.
Risk
Debt: Taking on debt raises risk: Interest charges increase your company’s break-even level, there’s the possibility of foreclosure if the lender can’t be paid, and principal and interest payments soak up cash flow that could be used in stressful times. In many cases, small-business loans involve pledging personal assets, including your home, as collateral.
Equity: The investors assume nearly all the risk.
Winner: Equity.
Cash flow
Debt: Interest payments and bank fees are tax-deductible. Taking on debt is also cheaper in the long run than the time and consulting fees involved in selling equity in a company.
Equity: There are no periodic payments, but there are sizable upfront costs associated with funding rounds: advisors, lawyers, outside accountants, extensive travel and entertaining potential investors.
Winner: Debt.
Payback horizon
Debt: Debt can be short term, with lines of credit that finance cash-flow swings, or long term, with loans of seven or 10 years (or longer with real-estate loans).
Equity: Equity financing is by nature a long-term deal that’s more appropriate for sizable investments in equipment or real estate.
Winner: Debt.
Reporting and compliance
Debt: Assuming you’re careful not to violate the covenants listed in a bank loan, all you need to do is make your minimum monthly payment on time.
Equity: All investors will want and be entitled to regular reports of what’s going on with your company. Does your accounting staff have the expertise and bandwidth to handle these reports? In addition, you may face monthly board meetings.
Winner: Debt.
Effort and expense
Debt: Getting a bank loan is a straightforward process, although it can require time to gather documents and prepare the loan application.
Equity: You can work full time for months to close a VC round. Few can afford to take their eyes off the business for that long.
Winner: Debt.
First published on Entrepreneur.com
