Business financing: Lenders or Investors?
Should you go to your local bank and apply for a business loan? Or should you look for a local investor? The decision is a challenge for small business owners.
Equity financing involves selling a partial interest in the company to investors. The equity, or ownership position, that investors receive usually takes the form of stock in the company. Equity investors become part-owners/partners in the business, and thus are able to exercise some degree of control over how it is run. In contrast to debt financing, which includes loans and other forms of credit, equity financing does not involve a direct obligation to repay the funds.
Equity investors primarily seek growth opportunities, so they are often willing to take a chance on a good idea, and they can be good sources of advice and contacts for business owners. Debt financiers primarily seek security, so they often require the business to have a good track record.
Having an investor write you a check may seem like the perfect answer. After all, it’s money without the hassle of repayment or interest. But it comes with strings attached — you must share the profits. Equity financing is available from a variety of sources.
Since their investments have higher risk, investors expect a large return. In general, venture capital firms are most interested in rapidly growing, new technology companies. They usually set stringent policies about the companies they will consider, based on industries, technical areas, development stages, and capital requirements. As a result, venture capital is not available to many small businesses.
Closed-end Investment Companies
They are similar to venture capital firms but have smaller, fixed (or closed) amounts of money to invest, and they usually concentrate on high-growth companies with good track records rather than startups. Investment clubs are groups of private investors that pool their resources to invest in new and existing businesses within their communities. These clubs have less formal investment criteria than venture capital firms, but they are more limited in the amount of capital they provide.
There are databases and venture capital networks to help link entrepreneurs to potential private investors.
Advantages to equity financing
• It’s a good option if you can’t afford to take on debt and channel profits into loan repayment.
• You tap into the investor’s network, which may add credibility to your business.
• Many investors take a long-term view and don’t expect an immediate return on their investment.
• You’ll have more cash on hand.
• There’s no requirement to pay back the investment if the business fails.
Disadvantages to equity financing
• It often requires returns that are more than the rate you would pay for a bank loan.
• The investor will require some ownership and a percentage of the profits.
• You may have to consult with investors before making decisions — and what if you don’t agree.
• In the case of irreconcilable differences, you may need to cash in and the investors will run the company without you. It takes time and effort to find the right investor.
The relationship with a bank that loans you money is very different. Debt financing involves borrowing money from a lender, and the borrower must repay the lender, usually with interest. Some sources of debt financing work for startups, others work for well-established firms.
To have immediate access to cash, a business may be able to sell a percentage of its accounts receivable to a factoring company, which then collects the money from the customer. The debt must be paid back to the factoring company, plus interest, which is often quite high.
Businesses can receive “trade credit” from their suppliers by negotiating the option to pay later. Say a retail startup needs inventory. The wholesaler could sell products to the startup, but instead of immediate payment, extend the payment terms to 90 days.
Bank and Credit Union Loans
Also called “term loans,” bank and credit union loans are the most well-known type of debt financing. These loans typically require monthly payments on the principal plus interest. However, traditional business loans can be difficult for a startup, or even established small businesses, to obtain for lack of collateral or a good credit history.
Loans from Relatives — or Yourself
Business owners can take money from their relatives or personal funds without exchanging for equity. Instead, a formal agreement acknowledges the capital infusion as debt. Peer-to-peer lending is another form of debt financing that doesn’t require the participation of a traditional financial institution. Sites like Prosper.com and Peer-Lend.com facilitate these transactions.
Also called “overdraft lines of credit,” overdraft agreements can be established. The bank establishes a limit to the account, and the business owner is allowed to withdraw up to that limit — even if there are insufficient deposits to cover it. The overdraft amount is charged interest that is repaid with the principal.
Advantages to debt financing
• The bank or lender has little say in the way you run your company and does not have ownership in your business.
• The interest on the loan is tax deductible.
• Loans can be short or long term.
• Principal and interest are known figures you can plan in a budget.
Disadvantages to debt financing
• Money must be paid back within a fixed amount of time.
• If you rely too much on debt and have cash flow problems, you may have trouble repaying the loan.
• If you carry too much debt you will be seen as “high risk” by potential investors — which will limit your ability to raise capital by equity financing in the future.
• Debt can make it difficult to grow because of the high cost to repay the loan.
• The business owner is often required to personally guarantee repayment of the loan.
Most businesses opt for a blend of equity and debt financing. The two forms of financing can work well together to reduce the downsides of each. The right ratio will vary according to your type of business, cash flow, profits, and the amount of money you need.
Before creating the Roaring Fork Business Resource Center, Ms. Lowenthal served as the Executive Director of the Carbondale Chamber of Commerce and held management positions in law firms and other professional service organizations in Chicago, Philadelphia, and New York City. She can be reached at (970) 945-5158 x3 or firstname.lastname@example.org.
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