Many business owners come to a point when they need to raise capital to continue growing the company. They don’t want to sell the business. Perhaps they simply enjoy their work or are on a growth trajectory and firmly believe they can get significantly more money if they sell later.
They must find outside capital.
While there are many ways finance your company, the two broad choices are equity or debt. Each can offer similar benefits — immediate capital to grow your business — however, they can have different implications.
Say you are running a $1 million revenue ecommerce business. To raise capital, assume you have the option to take a $100,000 loan at a 10 percent interest rate, or trade 10 percent equity interest (ownership) for $100,000. Both options will generate $100,000 to grow your business.
Now assume your business makes $300,000 profit per year. If you had taken the loan, you would owe $10,000 in interest ($100,000 * 10 percent) to the debt provider and keep $290,000 in profits. On the other hand, with equity you would commit 10 percent of the profits, or $30,000, ($300,000 * 10 percent = $30,000) to your equity investor, leaving you with $270,000 in profit. In this scenario, debt is the cheaper alternative.
Not only is the debt cheaper in that scenario, but once you pay off the loan you keep all of the profits going forward. The equity investment, however, is permanent. The investor owns 10 percent of the company forever.
But what if your business isn’t growing that predictably?
Banks or other lenders are typically less willing to lend to unpredictable businesses since the company has a significant risk of default. If they did make a loan, the interest rate would likely be high and could threaten the company’s limited cash flow. Equity, by contrast, is safer in this situation. If you sell 10 percent of your business for $100,000 and you don’t break even next year, you won’t (typically) owe anyone money.
Many stable companies (big and small) often look to debt first because of its relatively low cost. As long as your revenues are predictable, it often makes sense to take on debt for new capital.
Just because debt is cheaper doesn’t mean it’s always preferable, however. Depending on the current state of your company (and the economy), risk is also a necessary consideration.
One of the biggest risks to consider with debt is the company’s current capital structure. If your company had $1 million in revenue last year and made $150,000 in profit, taking a loan that requires $120,000 in annual interest and principal payments annually could be a significant risk.
Having a high debt-to-equity ratio can also make it difficult to raise capital. If you’re at risk of defaulting on your loans, many investors will fear that your company is unsustainable. Equity investments don’t typically have the same default risk as debt investments. An acceptable debt-to-equity ratio for small businesses greatly depends on the business, the industry, and the specific circumstances. Ready Ratios, a financial analysis software firm, offers these guidelines.
A primary risk of equity occurs if you need to raise more capital in the future. Typically, outside investors (current or new) will provide more capital for the business in exchange for more equity. Over time you can lose control of the business you built for years.
Overall, equity financing typically has lower financial risks for a business, though it can get tricky for you as an owner if you need too many rounds of financing. Debt, on the other hand, can be much riskier in both the short run and, if you have to refinance repeatedly, over the longer run if your profitability is unpredictable.
Depending on the type of loan you choose or the amount of equity you give up, you’re entering into a contract that could limit your future options. In that manner, debt provides less flexibility than equity.
In most cases, once you begin taking on debt, you will need to pay down principal before you can begin taking on more loans. While this cash burden can prove limiting, the biggest challenge is often the covenants associated with the loans. For example, banks will often require quarterly or monthly financial statement, have requirements on what your business is or is not allowed to spend money on, and may reserve the right to approve strategic decisions. The oversight can hamper a fast growing business if the bank or banker doesn’t understand your business.
An equity investor could have the same stipulations. But although equity comes at a higher cost, it generally provides more flexibility than a loan. As long as you don’t give up a controlling interest in your company, you are in a position to direct the outcome of your company’s future.
The decision to take on debt or giving up equity to finance your company is often influenced by many factors, including the owner’s lifestyle choices, the business’s cycle, market trends, macroeconomic influences, a desire (or not) to eventually sell the business, and more.