Small business owners know that there’s nothing more important to the success of their venture than cash on hand. Even businesses that are doing well have cash flow issues and a lack of a cash reserve prevents you from making timely investments, covering your overhead, and staying afloat after an emergency.
Having enough funding is especially difficult in the early years, when your business is still a startup, as you figure out your relationships with suppliers and your demand among customers. That’s where business financing most often comes in.
Debt vs. Equity
There are different kinds of financing that business owners can explore. Two of the most common and broadest categories are debt financing and equity financing.
Both types of financing come with pros and cons and may be more or less appropriate for your business at certain stages. Understanding the risks, rewards, and details of each kind can help you decide which is best for your small business, right now.
What is debt financing?
Debt financing is when you receive some form of funding from a lender, which you’ll pay back, plus interest, over a certain timeframe. This financing could be a business loan, a business line of credit, inventory or invoice financing (when you borrow money against what you own or are owed), or even a business credit card.
Traditionally, a bank was your best bet for finding a lender for financing. In recent years, a new class of alternative, online lenders have cropped up, offering faster and more accessible financing to small businesses (in exchange for higher interest rates).
Debt financing is the most common route business owners take to financing their business. Recent data from the SBA shows that over $600 billion in loans was deployed from June 2015-June 2016, and that number has likely grown due to the strength of the economy of late.
The relationship between a lender and a borrower (in this case, the small business) is financial. Once you repay your loan, you owe your bank or online lender nothing, and they have no further influence on your business dealings. This is quite different from equity financiers.
What is equity financing?
Equity financing is when someone—an angel investor, a VC group, a rich friend—invests money in your business, in exchange for a certain percentage of ownership in your company going forward. If you’ve seen the show “Shark Tank,” you’ve seen equity financing at work.
For the business owner, the appeal of equity financing is obvious: They receive access to capital in exchange for a lesser piece of the pie when (or if) the business realizes its full potential. Their personal liability, if the business fails, is limited: The investors will take the loss just as much as they will. In a sense, the responsibility of making the business a success becomes a shared endeavor. That can be very appealing to business owners taking a big swing at an ambitious business idea.
Equity financing is also a better way to get your hands on capital that is out of reach for many small business owners. Venture capitalists invest millions of dollars in a business, while business loans can be for anywhere from a few thousand dollars up to a million.
The catch is that from then on, your investor or investors will have the decision-making power to rival yours. In a sense, you give up a lot of what is appealing about being a business owner (namely, your autonomy) in exchange for access to serious funding.
The expectation from here out is that you deliver a major payout for your investors. You’re no longer just looking to build a stable, profitable business, but a lucrative investment that will, eventually, make you and your new partners rich. Companies like Uber and Airbnb were built in this mode.
Which type of financing is better?
Imagine your business is a boat on the sea. You have engine trouble and your boat breaks down on your way to delivering a lucrative bit of cargo.
In debt financing, someone comes along and lets you lease their extra engine, getting you to shore and your payday—and you pay your fellow captain a bit extra for their trouble. Afterward, you both go on your way.
In equity financing, a big boat comes along and invites you and your cargo to hop in. This boat’s captain knows an even better place to offload your cargo, where you’ll make more and can buy another couple of boats to deliver even more cargo. You and your original cargo are still the main players, but you can no longer steer your own way to shore. You’ve agreed to let someone else drive and to split the profits with them as a result.
Which one of these scenarios is “better”? It depends on your perspective, and what you’re looking to get out of being a business owner.
There’s also another important consideration: The equity financing scenario is much less likely to happen. Perhaps, sticking to our analogy, the big ships of the ocean will hardly ever notice or recognize your little boat out there.
Less than 1% of startups receive venture capital funding in a given year. That means your business will need to be a “unicorn” for investors to even consider it. You are much more likely to qualify for a small business loan than for investment, especially if you run a more traditional business.
Here are a few more things to keep in mind when you’re choosing (if the option to choose is available to you) between debt financing and equity financing:
How big are your capital needs?
Do you need $10,000, or $100,000? A business loan or line of credit is a good option—since that’s not enough money to consider giving up control of your business over. Do you need $10 million? That’s a different story: You’re probably not getting a business loan that comes close to that amount, so equity financing will be your path forward.
Do you need financing right away?
Again, covering payroll this month after a few unexpected expenses popped up isn’t worth selling off some of your business. That’s a better fit for debt, as well.
Additionally, the process for obtaining a business loan can be a few days or weeks (occasionally months, if you are applying for a large bank loan). The process for equity financing takes much longer, so if you need cash next week, a loan is the move.
Do you want more than just financing?
After you jump on that big boat on your way to shore, you’ll trade stories with your fellow captains and shipmates. Getting equity financing means getting the advice, perspective, and connections of your investors, who are tuned in to the world of business that you can’t touch just yet. Debt financing comes with no such mentoring.
At the end of the day, debt vs. equity isn’t a decision that most small business owners will have to make. Many will work with debt financing to maintain control of their business while growing responsible; a select few will look to equity financing to help them scale to huge heights. A couple more may combine the two—using equity to scale, and then debt to keep them going until the next round of equity financing. Other options, like revenue-based financing, abound.
That doesn’t mean that you shouldn’t be well-versed in all possibilities. Understanding the ins and outs of both debt and equity financing will make you a more informed small business owner. That way, if the day does come where you can choose which path to take, you’ll know where each one will take you.
Eric Goldschein is an editor and writer at Fundera, a marketplace for small business financial solutions such as small business loans and credit cards. He covers finance, marketing, entrepreneurship, and small business trends.