What is debt financing?
Simply put, debt financing is when you take on debt to put money into your business.
An example of this is a commercial bank loan, in which you borrow money from a bank and then pay the loan back over time, with interest. You’ll likely need collateral to get this type of loan, such as property or equipment.
Another example of debt financing is merchant cash advances. With this type of loan, you repay using the money you get from your business’s debit and credit card sales. This type of loan can come with costly interest rates, but it’s a fast way to infuse cash into your business when you don’t have much collateral.
There are also revolving loans and business credit cards, which are lines of credit you use when you need to.
The advantage of debt financing is that your lender won’t have any control over your business. (And the interest you pay is tax-deductible.)
The only disadvantage is that you have to qualify—and you also have to be sure you can repay the loan, which will be more expensive when interest rates are high.
What is equity financing?
With equity financing, you sell a part of your business to infuse capital into your business. It’s an option if you have trouble getting a traditional loan or don’t want to incur any more business debt.
One way to get equity financing is through one investor, who buys a stake in your company. These are sometimes called angel investors.
Another option is to get equity financing using venture capital, which comes from a person or a group that invests in businesses they see as having high growth potential.
You could also explore equity crowdfunding, which is raising funds from many people who invest small amounts.
The good news is when you choose this option, there’s nothing to pay back and no interest rate to worry about. But once someone has bought a stake in your business, they have a say in how it’s run—and you have to share your profits with the investor.
Is the lower cost of debt worth the default risks if repayments can’t be made? And is equity flexibility worth giving up part of the business? Talk to your bankers, advisors, and management team about the source that fits best with your next capital raise.
Is debt or equity cheaper?
The common knowledge is that debt is usually cheaper than equity, given that you can take a tax deduction on your interest payments and that lenders expect lower returns than investors would.1
But it also depends on how your business is doing now, and how you’re estimating your future profits. If a business ends up going under, then equity financing would have been cheaper. But if you borrow money and your business closes, you still need to repay the loan, even though you are no longer getting any income from that business.
Experts predict that it will become increasingly difficult to find willing investors. Or if they are willing, they might ask for a larger stake in your business than before, so choosing equity might be a challenge.2
Change your debt-to-equity mix.
What if you need more capital or want to access some of the value tied up in the company’s equity? There are several ways to go about it. Start with these fundamental questions:
- What’s your growth strategy—organic or acquisition?
- What are your liquidity needs?
- Do you have cash flow issues (inflated accounts receivable, seasonal fluctuations)?
- What’s your current ownership structure and succession strategy?
- Are you willing to trade equity for capital?
Outlining your capital strategy will also shed some light on your ambitions.
If you’ve got a fully committed balance sheet, your capacity for additional acquisitions will be limited. Your willingness or reluctance to relinquish ownership of your business will determine if an equity solution can be used for additional capital beyond your capacity for debt financing.
Equity buyback
You may be able to change your company’s equity-to-debt balance. If your business relinquished capital during a startup or growth phase, you can reclaim or even recapitalize that equity through debt financing.
A direct seller and marketer of natural food supplements secured $130 million in credit with our help to buy back a significant portion of the equity it had previously sold to a private equity firm while also gaining access to additional working capital.
Debt refinancing
Use debt to refinance capital at a better interest rate. Be sure to monitor the interest rates of your existing loans and lines of credit. Keep in mind that lowering your company’s overall debt servicing costs makes it easier to obtain additional capital in the future.
Adding debt
Startup businesses aren’t usually well-suited for the fixed payments required by most debt obligations. Early-stage capital is often tied to equity, but it doesn’t have to stay that way. When cash flow predictability increases as your business matures, you may want to consider shifting more debt to your capital mix. Your company can trade debt for owner equity or use it to help fund your next capital raise.
Reducing debt
In later phases, your business may experience cash flow issues due to the high cost of debt servicing. This is typical of any highly leveraged company with a large debt-to-equity ratio. Your business will be seen as a risk, which will make adding debt more expensive. Raising more equity or using cash flow to retire debt can help get your company’s capital mix back in line.
