Imagine you want a $1 candy bar, but you only have 50 cents, and your friend has 50 cents, too. You have two options: You could borrow 50 cents, in which case you get the whole candy bar to yourself, but you have to pay her back later (with 2 cents interest). Or, you could split the candy with her, in which case you get only half the candy but don't have that 52 cents hanging over your head. In a chocolate-coated nutshell, those are the trade-offs in using either debt or equity to finance a business.
Debt Financing Advantages
Debt financing is nothing more than borrowing money. The chief advantage of borrowing money as opposed to accepting money from an investor is that the lender only wants to get its money back. Unlike an equity investor, a lender doesn't have an ownership stake, so it doesn't have – nor does it usually want – any say in how you run your business.
The return that the lender expects on its money is clearly spelled out in the loan contract: It's simply the interest on the loan. The profits you generate are all yours (except for the taxes, of course). Further, the interest is tax-deductible.
Debt Financing Disadvantages
On the other hand, with debt financing, you're obligated to pay the money back, regardless of whether you can afford to. During slow periods, revenue may shrink, but the loan payments don't. Even if the business fails, the lender will still want its money back, which may mean seizing the business' assets. Because many entrepreneurs finance their startups with credit cards, second mortgages and other personal debt, the end result of a business failure could be personal bankruptcy.
Debt financing can also be hard to get, especially for a young company. Banks generally prefer not to lend money to high-risk enterprises, and young companies are by definition high risk. Finally, there's only so much money you can borrow before the debt starts eating up your company, as you're forced to commit resources to loan repayments and interest rather than growing the business.
Equity Financing Advantages
With equity financing, you don't have to pay anything back, because you're actually selling partial ownership in the company to investors. If the business fails – well, it's their business, too, so it's also their loss. In addition, because you're not making loan payments, you have more money to put into growing the business, and you're less likely to be caught in a cash squeeze if business slows down. Also, if you pick the right investors – or, really, if the right investors pick you – they can provide invaluable assistance in the form of management expertise, business contacts and access to other sources of capital.
Equity Financing Disadvantages
Equity financing means giving up at least some control over your company. Investors don't put their money into companies because they're pure of heart – even the hands-off types known as "angel" investors. They expect to see a return on their money, and if they don't get it, they're going to be up in your ear with suggestions or demands.
Even if your investors are making a nice profit, they may think they should be getting more. It's their company, too, after all. It's not uncommon for the founders of a business to find themselves forced out by their own investors.
- Advantage & Disadvantage of Equity Capital
- Rights of Stockholders & Bond Holders
- The Difference Between Stocks, Bonds & Mutual Funds
- How Can Smaller Investors Obtain Access to Private Equity Investment?
- What Is a Convertible Promissory Note?
- How to Calculate Leverage Ratio
- Importance of a Prospectus
- Difference Between Preference Share & Equity Share