Debt Versus Equity Financing of Your Small Business 💲💲💲
Two Types of Funding
Two kinds of funds are potentially available to the entrepreneur: debt and equity. This brief piece discusses the two types of funding, outlining their pros and cons from the entrepreneur’s perspective. Specific examples will also be provided.
First, debt funds are borrowed from a creditor and must be repaid (Hatten, p. 236). The pros of debt funding include: 1) there is no need to sacrifice a portion of the ownership rights to the business; 2) the fees and interest on the debt may be tax deductible; 3) it provides immediate cash without reporting responsibilities; and 4) once the debt is paid, there is no longer an obligation (www.brandongaille.com, 2020). More specially, debt financing keeps everything under personal control; it is possible to deduct the costs of funding as an actual business expense; there are generally no stipulations on how the funds may be spent; and debt financing eventually disappears. An example of debt financing includes bank loans, which are the most common type of debt financing; and bonds, which involve investors loaning money to your corporation for a defined period of time at a specific interest rate (www.thestreet.com, 2020).
Conversely, the cons of debt funding include: 1) The money from debt financing has to be paid back; 2) Interest rates could be very high; 3) there is no guarantee of approval; and 4) debt financing naturally reduces the available amount of cash liquidity. More specifically, it must be underscored that the funds must be paid back; the interest rates may be high and this type of financing could cost a lot; a lender does not have to extend debt to a business even if its credit is very good; and a business’ performance varies month-to-month and year-to-year, which debt financing does not take into consideration or even “care about” (www.brandongaille.com, 2020).
Second, equity funds are supplied by investors in exchange for an ownership position in the business (Hatten, p. 236). The main advantage of equity financing is that there is no obligation to repay the money acquired through it. Additionally, “credit issues will be gone”. For instance, if a business lacks creditworthiness – through a poor credit history or lack of a financial track record – equity can be preferable or more suitable than debt financing. A business owner can also learn and gain from partners, because with equity financing, it is possible to form informal partnerships with more knowledgeable or experienced individuals. Some might be well-connected, permitting the business owner to potentially benefit from their knowledge and their business connections (www.thehartford.com, 2020).
Conversely, the cons of equity financing include: 1) the profit is shared; 2) loss of control; and 3) potential conflict). More specifically, investors will expect a share of the profits; the price to pay for equity financing and all of its potential advantages is that a business owner needs to share control of the company; and sharing ownership and having to work with others could lead to some tension and even conflict if there are differences in the approach to running the business (www.thehartford.com, 2020).
Take Care in Choosing
In sum, there is much for an entrepreneur to consider with respect to the pros and cons of debt and equity financing. Experts caution that much care should be given to each of these approaches to financing a new business. Research conducted to this brief piece concurs with that conclusion.
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