You’ve discovered a great business idea, done your research, determined success is probable, and developed a great plan to launch and guide the endeavor. Now all you need is the money to turn your dream into reality. Raising the necessary capital for a new venture can often be the most challenging aspect of getting a new business off the ground. Unless you are one of the fortunate few who can self-fund the project, you must find other sources of money, the proverbial OPM (Other People’s Money). In the financial arena, this funding will usually fall into one of two main categories – debt and equity. Which one is better? The answer, like so many others, is – it depends.
Funding a Business - Debt or Equity?
By Kerry Woodson
You’ve discovered a great business idea, done your research, determined success is probable, and developed a great plan to launch and guide the endeavor. Now all you need is the money to turn your dream into reality. Raising the necessary capital for a new venture can often be the most challenging aspect of getting a new business off the ground. Unless you are one of the fortunate few who can self-fund the project, you must find other sources of money, the proverbial OPM (Other People’s Money). In the financial arena, this funding will usually fall into one of two main categories – debt and equity. Which one is better? The answer, like so many others, is – it depends.
Debt financing is the vehicle with which most people are familiar. It involves getting a loan from someone and then paying it back at some point in the future, with interest. It’s what usually first enters an entrepreneur’s mind when thinking about getting money for the business. Sources can include friends and family, banks, and other entities.
The advantage of debt funding is that it is relatively low cost although it might not necessarily be cheap. Interest rates can be quite high for a risky endeavor, if gotten at all. The low-cost aspect is relative to the long term price of giving up a portion of ownership. Assuming the company’s return on assets is greater than the interest rate, the owners make money even after interest charges. Another aspect contributing to the low-cost nature of debt is that it is temporary and is eventually paid off and no longer a drain on the company’s cash flow, which brings us to the debt downside.
Debt financing has its disadvantages as well. Not only can it be hard for a startup enterprise to obtain, it can be risky for the business. The biggest drawback is the required repayment. It’s funny how lenders expect to be paid back – on time. This obligation is present whether the company is doing well or not. The company must be generating enough cash to cover the interest expense AND the repayment of principal. Failure to make the required payments can put a company out of business due to foreclosure, etc. Don’t be surprised if a personal guarantee is required, meaning that if the business fails, you are still personally responsible to repay the debt.
Equity, on the other hand, is generally less risky but can be more expensive to the founder. The comment I repeatedly hear from would-be entrepreneurs is “I don’t want to give up any ownership.” To which I ask, is it better to have 100% of nothing or 70% (or whatever) of something hugely successful?
The advantage of equity over debt is the relative safety to the company’s cash flow. Generally, equity owners get paid only if the company is profitable and chooses to distribute dividends. In other words, in a common arrangement, there are no obligatory monthly payments that can stress the business as it builds or experiences tough times. While definitely not easy to obtain, a solid business opportunity can often attract potential investors even when the project is not yet “bankable” for debt financing.
So what’s the catch? Will an investor provide capital and expect nothing in return? No. If a person invests in a risky venture (they all are), he/she demands to be compensated for that risk. Instead of a guaranteed interest-only return, an investor participates in the upside potential of the company in both profits and future valuation. It’s not uncommon for a shareholder to expect a 25-50% annual return, obviously much higher than an 8% loan. To help ensure those returns, the investor also might want to have input on the running of the company. It can be like having multiple cooks in the kitchen so choose wisely when it comes to accepting someone’s money and consider all the ramifications.
The proper capital structure is unique to every business and depends on many variables like creditworthiness and business potential. Organizations like The Small Business Development Center at many colleges/universities provide free business counseling to help entrepreneurs start and grow their businesses.
By Kerry Woodson
You’ve discovered a great business idea, done your research, determined success is probable, and developed a great plan to launch and guide the endeavor. Now all you need is the money to turn your dream into reality. Raising the necessary capital for a new venture can often be the most challenging aspect of getting a new business off the ground. Unless you are one of the fortunate few who can self-fund the project, you must find other sources of money, the proverbial OPM (Other People’s Money). In the financial arena, this funding will usually fall into one of two main categories – debt and equity. Which one is better? The answer, like so many others, is – it depends.
Debt financing is the vehicle with which most people are familiar. It involves getting a loan from someone and then paying it back at some point in the future, with interest. It’s what usually first enters an entrepreneur’s mind when thinking about getting money for the business. Sources can include friends and family, banks, and other entities.
The advantage of debt funding is that it is relatively low cost although it might not necessarily be cheap. Interest rates can be quite high for a risky endeavor, if gotten at all. The low-cost aspect is relative to the long term price of giving up a portion of ownership. Assuming the company’s return on assets is greater than the interest rate, the owners make money even after interest charges. Another aspect contributing to the low-cost nature of debt is that it is temporary and is eventually paid off and no longer a drain on the company’s cash flow, which brings us to the debt downside.
Debt financing has its disadvantages as well. Not only can it be hard for a startup enterprise to obtain, it can be risky for the business. The biggest drawback is the required repayment. It’s funny how lenders expect to be paid back – on time. This obligation is present whether the company is doing well or not. The company must be generating enough cash to cover the interest expense AND the repayment of principal. Failure to make the required payments can put a company out of business due to foreclosure, etc. Don’t be surprised if a personal guarantee is required, meaning that if the business fails, you are still personally responsible to repay the debt.
Equity, on the other hand, is generally less risky but can be more expensive to the founder. The comment I repeatedly hear from would-be entrepreneurs is “I don’t want to give up any ownership.” To which I ask, is it better to have 100% of nothing or 70% (or whatever) of something hugely successful?
The advantage of equity over debt is the relative safety to the company’s cash flow. Generally, equity owners get paid only if the company is profitable and chooses to distribute dividends. In other words, in a common arrangement, there are no obligatory monthly payments that can stress the business as it builds or experiences tough times. While definitely not easy to obtain, a solid business opportunity can often attract potential investors even when the project is not yet “bankable” for debt financing.
So what’s the catch? Will an investor provide capital and expect nothing in return? No. If a person invests in a risky venture (they all are), he/she demands to be compensated for that risk. Instead of a guaranteed interest-only return, an investor participates in the upside potential of the company in both profits and future valuation. It’s not uncommon for a shareholder to expect a 25-50% annual return, obviously much higher than an 8% loan. To help ensure those returns, the investor also might want to have input on the running of the company. It can be like having multiple cooks in the kitchen so choose wisely when it comes to accepting someone’s money and consider all the ramifications.
The proper capital structure is unique to every business and depends on many variables like creditworthiness and business potential. Organizations like The Small Business Development Center at many colleges/universities provide free business counseling to help entrepreneurs start and grow their businesses.
RSS Feed