Equity Financing and Debt Financing for SMBs
There are several aspects that contribute together to make a business successful in the long run. Besides a scalable business model, the right employees and a proper strategy, one of the important factors that can either make or break any business is funds.
When it comes to collecting funds for your business, there are several options to try out. For small businesses, debt and equity financing are two of the most secure funding methods
. The majority use a combination of both these small business financing
methods, however each has some distinct pros and cons.
Companies can choose from the afore-mentioned financing options depending on their business requirements. The choice, in most of the cases, depends on factors like which funding source is more accessible, the cash flow it delivers and the level of control a company needs to maintain for its principal owners. However, understanding how both of these financing options function can help you figure out the one that can appropriately meet the financial needs of your business.
Debt Financing – An Overview
In the simplest of terms, debt financing refers to taking a loan for funding your business. The money that is borrowed as a loan needs to be paid back by the borrower, typically with interest. You may be bound by a set timeframe to repay the amount you have borrowed. However, this depends on the type of debt financing model you are opting for.
deally small business debt financing comes in the following forms:
- Term Loans
- Small Business Administration Loans
- Business Lines of Credit
- Inventory loans
- Invoice factoring or invoice loans
- Merchant cash advances
- Equipment loans
Any type of personal loan - whether borrowed from a lender, a bank or a credit union would come under the debt-financing category. Debt financing can be further differentiated on the basis of purpose and the need it serves for a small business.
For instance, invoice loans and merchant cash advances are often categorized as short-term debt financing. In this model, businesses end up borrowing a stipulated amount of money which is repaid over some months instead of years. This type of micro-financing model may prove to be ideal for businesses trying to address temporary cash flow issues while clearing working capital expenditures.
On the other hand, an equipment loan is a separate type of debt financing scheme where the opportunity to repay the fund over several years exists. Instead of funding short-term needs, these loan types can help fulfil long-term business goals.
Equity Financing – An Overview
In case of equity financing, a small business can receive funding from one or more investors depending on the requirement. The funding can be provided by venture capitalists or individual angel investors. Angel investors often leverage their own private capital to invest in growing businesses or startups. Venture capitalists on the other hand, also invest in new business but the difference is they often do not use their own money. Rather, the money invested by venture capitalists comes from corporations or endowments.
Whether an angel investor or venture capitalist firm provides equity funding to a particular business, the common denominator is that the business has to typically hand over an ownership stake within the company in lieu of the capital. In case the business becomes successful, the venture capitalists or angel investors who provided the requisite funds will also claim a share of the business revenue.
The following are the types of equity financing options available:
Initial public offering:
Businesses can provide an IPO or initial public offering when it first goes public. Going public essentially means that the shares of the company will be publicly traded on markets such as stock exchanges. If you go for this funding option then you will need to provide your initial offering in line with the guidelines established by the Securities and Exchange Commission (SEC). The SEC needs to approve and register all the IPOs. Once the offering is approved, the SEC will provide a listing date to the business when the shares would be made publicly available in the market.
Before this process, businesses can take appropriate steps to ensure that public investors are aware of the availability of the shares. By publishing a prospectus or deploying a campaign to attract investors, you can create the right buzz within the market.
An angel investor
is essentially an investor with assets that can provide micro or large scale funding for small businesses. Angel investors are groups or individuals who are looking to earn returns from their investments and they are typically quite choosy about the type of business in which they want to invest funds.
Some angel investor groups prefer investing in companies in their early stages of operation. They provide the much-needed technical and operational assistance to these companies to help them flourish.
Mezzanine financing is essentially a combination of equity and debt financing. In this financing model, the lender will provide the company with a stipulated loan amount. If the company performs well and garners good revenue, they will pay the loan back according to the negotiated financing terms. And, since it is a hybrid financing method, your company can show it as equity financing in its balance sheets.
Venture capitalists are organizations that provide small business financing in lieu of partial ownership of business or shares. However, they do not leverage personal funds to finance your business like angel investors.
The Pros and Cons of Debt Financing
- Debt financing can be an effective way for small businesses to collate much-needed working capital quickly. An online lender for instance, can deliver funds straight to your business account within a matter of days provided that your business meets all the requisite fund requirements. This can prove to be helpful, especially if you are required to cover working capital costs or if there’s an opportunity that requires quick decision making.
- Predictability is another aspect that makes debt financing a viable financing proposition for small businesses. If you end up having a fixed line of credit with a fixed interest rate and repayment schedule then you can surely enjoy peace of mind. An added bonus – the loan payment interests in debt financing are often tax deductible and it can help you reduce your tax liability.
- With debt financing, you ordinarily do not need to give away the ownership and control of your business which is perhaps the major benefit of this financing model.
As far as the downsides of the debt financing are concerned, there probably aren’t many except the fact that you will need to continue repaying the debt, even if the business doesn’t perform well. Defaulting on a single loan repayment window could negatively impact personal and business credit scores. In a worst case scenario, if you pledge any collateral as a security against the loan, then the lender could end up taking possession of the same in case of a default.
The Pros and Cons of Equity Financing
Unlike debt financing, equity financing comes with lesser pressures of cash repayment, since you are not paying off monthly instalments. Another aspect that makes equity financing an appealing option is the ease of approval associated with larger funds which is typically not the case with loans.
The risk associated with this financing model is also largely lesser, when personal assets and security collaterals are taken into consideration. For instance, if the business fails to earn revenue, the pressure to repay investors may not be as much. Rather than utilizing the profits to pay debts, you may continue investing to grow your business. But this comes at a cost. With equity financing, you may not be able to keep the lion’s share of profit with yourself.
When you are giving a portion of your ownership of the company, you are also letting go of profits. Your investors may also exercise special voting rights and manipulate your stance on key decisions, which may also lead to conflicts.
Selecting the Right Option for Your Business
While weighing on both the options, carefully consider all the pros and cons and only then move forward. Your decision to select a particular financing method may depend on the amount of funding you may require or the time you are looking at to process all your funds.