By:
“It takes money to make money.”
“It takes money to make money!”
In the process of starting a business, you’ve probably heard that adage hundreds if not thousands of times. “Yes!” I hear you saying, “I know that already! But where should that money come from?”
Sadly, there’s no quick and clever saying for that one. But that’s okay! We still have a relatively simple path to set you in the right direction.
For most business owners, your options for financing a business will most often fall into one of two categories: debt or equity.
Debt vs. Equity: What’s the Difference?
If you’ve ever obtained a student loan, a home mortgage, or even a credit card, you’re already familiar with debt capital. Simply put, debt financing is any scenario in which you receive money from a lender with an agreement to pay back the funds borrowed, plus interest.
Equity capital, on the other hand, is more unique to the financing of a business. With equity financing, you agree to trade ownership of a portion of your business to either a single investor or an investment firm (often called private equity or venture capital) in return for their agreement to cover some or all of the business’s startup costs. If the business is ultimately successful, the investor is entitled to a percentage of proceeds in the event of an acquisition/IPO or a percentage of profits generated, according to the terms of the equity agreement.
Now that we have a working understanding of debt and equity capital, how do you decide which blend of financing options to pursue for your early stage startup? The right answer will depend on your business’s individual needs and circumstances. Carefully consider each of these factors to decide between taking out a loan or finding an investor to fund your business.
1. Your Capital Requirements
How much money do you need to achieve your business goals? Start by creating a realistic budget for your first year of business operations, including large one-time expenses (such as purchasing equipment, designing a brand, or renovating a retail space) as well as ongoing costs. It’s easy for these numbers to become quickly inflated, so do your best to separate the dream list from the must haves. The number you end up with may go a long way toward dictating whether you pursue debt or equity capital for your business. Most equity investors look to spend at least $150,000, with many venture capital / private equity firms holding a $1 million minimum. If your financing needs aren’t at least in the six-figure rate, a small business loan will most likely be your best bet.
2. Your Funding Timeline
How quickly do you need money in hand? If you’re on a tight deadline, the extended process of working with an equity investor may not meet your needs.
While some online alternative lenders can process your application and get you cash in hand within as little as 48 hours, the process of connecting and negotiating with an angel investor or venture capital firm can drag on for months. You’ll need to get the investor’s attention for a meeting, wow them with your business model, negotiate a budget, set an equity agreement, and endure the back and forth of every request or recommendation your investor puts forth. Remeber, equity investors are diligencing your business to become partial owners.
If your business’s success hinges on taking advantage of a short-term opportunity, consider starting with a small business loan to get things off the ground. Once you’ve made it through the first phase of your business launch, you can always revisit bringing in an investor to help you fund long-term growth.
3. Your Risk Assessment
How certain are you that your business plan will succeed?
The downside of debt financing, of course, is that you’re on the hook to pay back the money you borrowed—no matter what. If your business goes under, you as the business owner can still be held personally responsible for any outstanding debt. In other words, you assume all the risk.
With equity capital, on the other hand, your investor only makes money when you do. If your business is very successful, the investor stands to make many times over the amount they put into your company. Equity financing is far more costly in that regard, as investors will get a “portion” of your success. But if things go south, you may not owe them money, but you’ll have some tough conversations with these investors ahead and will, of course, lose your own investment in the business. If your business idea is inherently high risk, working with an equity investor will help you protect your personal finances if things don’t go as planned.
4. Your Growth Expectations
If you have your sights set on a small, family-run business, you likely won’t have the profit potential that angel investors and venture capitalists are looking for. To make their investment worthwhile, equity funders are looking for startups with the potential to grow into substantially larger businesses with the material likelihood of being sold to a buyer at a higher valuation several years out. Not sure whether running a high-growth startup is right for you? Stick with debt financing to maintain more autonomy over your business’s future.
Are you still questioning whether debt or equity, or a combination of both is right for you? Let’s make this as simple as we can:
- Choose debt capital if you need a relatively small sum of funding and you’re on a tight deadline.
- Go for equity capital if you need a large sum of financing to make a long-term investment in building a high-growth enterprise.
- Have your sights on something in between? Go for both debt and equity capital. Get yourself started with a small loan or line of credit backed by your personal credit, then re-evaluate your company’s equity raise route once you have a clearer idea of your business’s future. Remember, this doesn’t have to be all one or the other!
It’s more than five words, and it doesn’t rhyme, but this bottom line will get you one step closer to actually obtaining the money it takes to make your business dreams a reality.
ABOUT THE AUTHOR:
Meredith Wood is the VP of Content and Editor-in-Chief at Fundera, an online marketplace for small business loans. Prior to Fundera, Meredith was the CCO at Funding Gates. Meredith manages financing columns on Inc, Entrepreneur, HuffPo and more, and her advice can be seen on Yahoo!, Daily Worth, Fox Business, Amex OPEN, Intuit, the SBA and many more.