Debt vs. Equity (post 1): Advantages and Disadvantages of Equity Funding

Today’s post is the first in a series that will explore the advantages and disadvantages of different types of financing, specifically debt vs. equity. In this initial post, I’ve highlighted some of advantages and disadvantages to using equity financing instead of debt financing in your small business.

It seems as though many start-up businesses are eager to jump on the equity bandwagon without ever considering debt financing. While investor money comes without the hassle of repayment or interest, it also comes with the significant burden of having to share profits with the investor. Despite the fact that you have to share profits with your investors, there are a number of advantages to using equity financing for your business.

The Advantages

Lower risk. Generally, it’s less risky to use equity financing rather than take out a loan from a lender because you don’t have to pay equity back like you would a loan. Equity can a good option for businesses that aren’t in a place where they can take on additional debt.

Equity tends to increase your credibility. If you can successfully raise equity for your business, it will likely boost your business’ reputation, at least with investors. Your ability to tap into investor networks will likely lend to the credibility of your business venture.

Long-term equity vs. short-term debt. In most cases with equity, investors will take a long-term view of the business, i.e. they typically won’t expect a return on their investment anytime soon (the key word being “typically”).

No repayments. With equity, you won’t have to budget for loan repayments out of your profits. Not having to budget a loan payment into your business’ monthly budget can mean the difference between the ability to hire additional employees to help grow your business. Furthermore, if the business ultimately fails, you’re not on the hook to the investors like you would be to the creditor in a debt financing scenario.

Increase Your Cash Flow. With equity, you’ll generally end up with more cash on hand that you can use for growing the business. Because investors are hoping to obtain a high return on their investment, they’ll generally prefer leaving their money in the business to help promote growth. The ability to reinvest money within the company is vital for many small businesses.

The Disadvantages

High returns. In order to persuade investors to invest, you may have to promise to pay higher returns than the rates you’d pay to a bank or other debtor if you took out a loan. Taking on such high returns can cripple many small businesses.

Giving up control of your business. When you raise financing through equity, you’re required to give up ownership, a percentage of profits, and, to some extent, control of the company. This is a difficult pill to swallow for many small business owners, especially those that have held onto control and ownership for a significant period of time.

It complicates the decision-making process. Before you make big decisions with respect to your business, you’ll have to consult your investor-shareholders. This can be an administrative hassle, and especially difficult if you don’t see eye to eye on the decision. For many small business owners, making decisions usually involves little to no consultation with anyone. Adding investors to the mix can be especially difficult if your used to making a decision on your own.

Extensive time and expenses. Finding the right investors for your company isn’t an easy task. It often takes a significant amount of time, effort, and money just to find the right investor.

Stay tuned for the next post in this series, which will highlight some of the advantages and disadvantages of debt financing.

If you’re interested in learning more about equity financing or how to raise money for your business, please feel free to contact us or submit your question to our free Q & A service.

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