Travis Meyer, CEO at Thynk Capital Holdings, is a serial entrepreneur and finance expert, passionate about the empowerment of entrepreneurs.
To accommodate for the financial demands of a growing business, companies generally have two options with regards to capital generation: equity or debt financing. Equity refers to raising capital through the sale of company shares, whereas debt financing is the generation of capital by loaning funds that are then paid back with interest over a period of time.
Which one is cheaper? The answer depends entirely on your business and how well it performs. Here, we will look into the pros and cons of both, so you can decide which option is best for you and your business.
The Pros And Cons Of Raising Equity
Equity financing can come in the form of corporate investors, venture capitalists, angel investors, crowdfunding or listing on an exchange with an IPO. One of the most attractive factors of equity financing is that there are no required periodic repayments, like there is with debt financing. There are also several other benefits: new equity partners should bring time, effort, expertise and experience to the team, and in addition, give the business access to strategic partnerships and markets that can take the business to new heights.
However, introducing new shareholders to a business increases the potential risk for a clash in vision and culture. This can create turbulence within the flow of a company and result in delays in crucial decision-making.
Additionally, when owners are required to hand over a portion of their ownership, by diluting their shareholding in the business, this reduces their overall control of the business. If the company flourishes in the future, becoming increasingly profitable and successful, then it may be obligated to pay a calculated percentage of those profits to the shareholders in the form of dividends—understandably, equity investors want to see a return on their investment. The only way to revoke that power is to buy them out, which will likely cost you more than the initial amount they invested in the business.
Most importantly, the real cost of taking on equity partners is realized when the business is sold at a later stage. Let’s look at an example to illustrate this.
A business, currently valued at $2 million, needs cash to fuel growth and decides to raise funds by taking on equity partners. The owner starts out at 100% ownership, which is worth $2 million. They sell 50% to investors, who invest $1 million into the business, which is used to grow it: marketing, distribution, etc. The business grows successfully and in five years’ time, is valued at $10 million. The business is then sold for $10 million. Because of the 50% ownership, the investors get $5 million and the owner gets $5 million.
If the owner had used debt financing instead of equity financing, they would have made $8 million from their initial $2 million, instead of only $3 million. However, this does not include the cost of repaying the loan, which will depend on interest rates. And this business might not have grown so quickly in five years had the entrepreneur not leveraged the investors’ experience, expertise and resources.
Thus, the question that entrepreneurs need to ask themselves is, “Do I need the money, or do I need a specific person on my team who can add their time, energy, expertise and network, as well as their money?”
Types Of Debt Raising
Businesses can access debt financing through an array of avenues including traditional bank loans, personal loans, lines of credit, business credit cards or alternative lenders.
• Traditional Banks
Traditional bank loans are an attractive option for well-established companies that do not want to give away control of their business.
Traditional bank loans are secure—meaning they require collateral against the loan—and therefore it can be difficult for small businesses to access this type of financing due to the stringent list of requirements. Small businesses are often turned away for not having enough collateral and/or for falling short of the credit score threshold. The traditional bank loan application can be a lengthy process and once approved, will result in debt that your business will need to pay back on a regular schedule.
• Alternative Lenders
Alternative lenders are non-institutional companies or individuals that provide quicker, smaller and more accessible loans to business owners. These loans are unsecured, meaning funding is provided outright without collateral; however, interest and fees will still apply. With fewer hoops to jump through, applications can be approved within a few days.
The downside is that alternative loan repayments can be more expensive than traditional bank loans due to the fact that the lender absorbs the risk and financial implication should your business go under. (Full disclosure: My company is an alternative lender.)
Raising Debt Versus Surrendering Equity
Deciding between debt and equity fundraising will depend entirely on your business and where you are in your startup journey. Present and future profitability, ownership and control requirements, and whether your business will qualify for either of the major loan options will play an integral role in your financing option decision.
On the one hand, procuring equity financing can be a good strategic decision for your business if you’re bringing the right partners on board, but you will need to be willing to surrender a portion of your company and its future value, as well as control.
Debt can be far cheaper than equity if your company grows to a point where it sells for a substantial sum. Then, instead of having to pay your shareholders out their percentage share, you retain full ownership and simply pay off the loan.
Most companies have a blend of both debt and equity financing. A unique business will always require a unique decision.