How to Manage Debt

Raising Capital: Should You Take on Debt or Issue Equity?

    If you own a capital-intensive business or won’t turn a profit for a few years, your personal investment probably won’t be enough to keep your startup going. To get more capital, business owners are usually faced with the choice of taking out a business loan or distributing owner’s equity. Both options offer distinct advantages but both can come at a very high price.

    Equity Advantages

    In some ways, equity financing is like getting free money for your business. You won’t incur any interest charges on equity and, if things go south, you’re not obligated to pay equity back. Aside from funding your business, an investor can also act as a mentor and strategic advisor. Your investor only gets a return if you succeed, so he has an incentive to help your business grow. Investors tend to have a large professional network so they can bring in new clients and vendors. They’re often willing to share general know-how and industry insights to help your small business avoid costly mistakes.

    Equity Disadvantages

    Although you may not pay interest on equity financing, it still comes with a cost. Investors expect a sizable chunk of ownership in exchange for equity financing. The exact percentage will depend on your business valuation and how much cash you’re expecting, but expect to lose between 10 to 50 percent of your ownership to an angel investor. It can be time consuming to find the right investor, and accepting equity financing is a complex process, so be prepared for a long close time and high legal bills.

    Aside from losing part of your business profits, accepting equity also means giving up some autonomy. Jake Dacillo, Marketing Manager at Balboa Capital, points out, “Issuing equity may result in tighter control by the investor in order to protect his equity stake, thereby taking some level of control away from the business owner.” Your investor may also have a personal agenda — like getting the business bought out or taking the company public — that you don’t share.

    Debt Advantages

    Taking on debt is a straightforward way to finance your business. Assuming that you’ve already developed a relationship with a bank, securing a loan is a relatively quick process. Plus, ending the transaction is easy. Dacillo notes, “A business loan can be consummated with a simple loan payoff. It may be more complicated to end an equity stake if the owner wishes to break ties with the investor.” Although you’ll pay interest for the cash, you won’t be giving up control or diluting your ownership.

    Debt Disadvantages

    It can take months or years for a business to transform cash into revenue. If you take out a loan, you’ll be subject to a strict repayment schedule, which means some of your equity will be tied up repaying the loan principal and interest. Unlike equity, you’re legally obligated to pay back your debt. If revenues don’t start coming in as soon as you originally expected, meeting your payment obligations can quickly become a huge financial burden. For this reason, you’re better off using debt for short-term purposes — for example, covering a seasonal decline in sales or a large unexpected expense — rather than using it to finance business operations.

    Although your bank won’t micromanage how you run your business, you still may be subject to loan covenants. Break them and you could be subject to fines, penalties, or an early repayment schedule.

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    Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.