Debt and equity are both tools that you can use to finance, operate, and grow your business. Each has its advantages and disadvantages and it's important to understand these differences before you decide which tool can best help you build your business.
Let's start with equity. Equity financing requires you to sell a portion of your company's equity in exchange for capital to finance your business. A major advantage of equity financing is that you can obtain this financing before having sales in hand. This makes it an appealing option for funding a prototype or starting from scratch.
Equity financing often yields a larger check than debt financing because equity partners want to reap the rewards of a successful business and are willing to pay into that growth.
However, there are drawbacks to equity financing. While it may seem appealing to get a big investment without needing sales in hand or a repayment plan, equity financing is not free.
Equity financing is more expensive than most people realize, as a percentage of all future profits and sales will be given up permanently. The equity partnership is a long-term commitment, not one that will end once you have earned a certain amount.
There is also a possible loss of control to consider. You may have to give up a seat on the board, for instance, and future decisions will have to be made with your private equity partner in mind.
James Bartel, of Sallyport Commercial Finance, also points out that equity financing can be difficult to obtain and put pressure on your business. "Private equity firms are motivated by huge profits and have the mindset that only one out of ten investments - or fewer - will pay off, while most entrepreneurs do not feel they need hockey stick growth to be successful." Also, Bartel cautions that it is a lot of work to make a pitch to a private equity firm. It requires more time, more money, and more effort than debt financing.
Debt financing involves borrowing money and repaying it, along with interest. There are some negatives to bear in mind when considering debt financing. For one thing, most debt requires a personal guarantee, though this is only applicable if the company fails and there are no assets left in the business to pay off the debt. Also, debt financing often has some type of requirement or covenant, such as debt service coverage.
You may run into barriers with debt financing based on where you are in the development of your business. "Debt cannot be used to fund an idea, nor can it be disproportionate to the collateral," says Bartel. If your only collateral is your elevator pitch, debt financing probably isn't for you.
But debt financing has some clear advantages. One major upside is that debt financing does not require you to give up any ownership in your company, which means the loss of control is minimal. And without a private equity partner looking for quick gratification, debt can allow companies to grow rationally.
There is also a set charge with debt financing and no additional costs for advice from a lender. Also, debt financing is possible for almost any type of business because there are many different types of lenders.
Sallyport, for example, is a debt lender that does not require covenants. They have some flexibility with guarantees, offering limited and validity guarantees. They can also handle unique situations, like foreign or government Accounts Receivable, milestone billing, non-dilutive funding, and non-bank lending when bank financing is only partially available or not at all.
So how do you know what is right for you? Think about the type of business you want to finance and your needs. Bartel suggests the following guidelines.
Equity financing is a good fit for:
- pre-revenue companies
- companies with massive research and development
Debt financing is a good fit for:
- more established businesses (especially for bank debt)
- companies needing to fill purchase orders
- companies that have turned business down due to lack of cash or cash flow
- seasonal or cyclical businesses and firms that have growth needs based on sales rather than future sales
Debt and equity are useful in different situations. It is important to explore your options, know the true cost of equity, and use debt when possible or when it makes sense for your business. For more on debt vs. equity financing, see Veristrat.