A Comparison of Business Financing Methods
From inventory and equipment to insurance and marketing, you purchase a variety of goods and services to run your business. That means you’ll need plenty of cash flow or have to secure funding to pay for it. While there are dozens of ways to finance your business, most are classified as either debt or equity.
What Is Debt Financing?
Debt financing involves borrowing money to fund your business’s operations. You’ll have to repay the borrowed money, typically with interest, as agreed upon by you and the lender. Debt financing is offered by banks as well as private lenders. The lender extends money to your business, which you must repay.
Interest rates for debt financing vary depending on factors such as your company’s cash flow, credit score, projected growth and whether it’s a secured or unsecured loan. With that said, most forms of debt financing have an interest rate of about 4 percent to 15 percent. Example: If you borrow $100,000, you can expect to pay about $4,000 to $15,000 in interest.
Common types of debt financing include:
- Small Business Administration (SBA) loans
- Non-SBA business loans
- Hard money loans
- Bridge loans
- Equipment financing
- Peer-to-peer (P2P) lending
- Loans from friends or family members
- Credit cards
- Lines of credit
- Personal savings
What Is Equity Financing?
Equity financing involves selling shares of your small business’s common stock to fund your business’s operations. You don’t borrow any money with equity financing. Instead, you raise capital by selling partial ownership of your company in the form of common stock.
Assuming your business is structured as a corporation, you might be able to finance it by selling stock shares to an investor. There are individual investors and large firms of investors who purchase stock shares in early and mid-stage corporations with high growth potential. If an investor believes your small business is poised to grow quickly, he or she may offer to purchase some of its stock shares. Because stock shares represent ownership, purchasing them allows an investor to own part of your small business.
Common types of equity financing include:
- Venture capital
- Angel investors
- Initial Public Offering (IPO)
- Mezzanine financing
Benefits of Debt Financing
Regardless of how your business is structured, you can finance it with debt. Because equity financing requires selling shares of stock to an investor, you can’t use this financing method is your small business is structured as a sole proprietorship or limited liability company (LLC). Rather, equity financing is only available to businesses structured as a corporation, such as an S-Corp or C-Corp. Debt financing, however, is available to both incorporated and unincorporated businesses.
While debt financing typically requires paying interest on the borrowed money, you can deduct interest fees from your business’s taxes. Whether you spend $500 or $5,000 on interest fees in a given year, you can claim them as a deduction to lower your tax liabilities for that year.
You won’t have to forfeit ownership of your company with debt financing. You’ve probably made a lot of sacrifices to turn your vision of a commercial enterprise into a reality. As a result, you might be reluctant to sell your business’s stock shares. Debt financing allows you to raise capital without forfeiting any ownership of your business. You’ll retain your business’s stock shares and, therefore, ownership of your company..
Benefits of Equity Financing
With equity financing, your small business won’t incur debt. Equity financing is essentially a sales transaction, so it won’t drag your small business into a bottomless pit of debt. You can sell some of your small business’s stock shares to an investor without it negatively affecting your small business’s cash flow.
You can also take advantage of professional expertise and guidance offered by equity investors. When an equity investor purchases some of your small business’s stock, he or she will want your small business to succeed. If your small business fails, the value of its stock shares will decrease, meaning the equity investor will lose money. If your small business succeeds, however, the value of its stock shares will increase, thus allowing the equity investor to make money.
Because equity investors want your business to succeed, they may offer guidance and expertise. An equity investor may recommend a new product vendor with cheaper prices, or he or she may recommend expanding your small business into a new, untapped market. Debt financing lenders, on the other hand, offer little or no guidance and expertise.
You don’t need good credit to secure equity financing; you can raise capital through equity financing with bad credit or no credit. When seeking debt capital, lenders will scrutinize your business’s credit history as well as your personal credit history to measure your risk of default. With bad credit or no credit, lenders will view you as a high-risk candidate, so they’ll either force you to either pay a higher interest rate or reject your loan application altogether.
Which is Best?
Each financing option has its own unique benefits. Debt financing is available to all businesses, including incorporated businesses, and doesn’t require forfeiture of ownership. In comparison, equity financing allows you to raise capital for your business without the obligation of repaying. Keep in mind, you don’t have to restrict your financing efforts to either debt or equity. You can use both types of financing to raise capital or look to alternative sources of lending, such as accounts receivable financing. This type of financing, also known as invoice factoring, allows companies to sell their unpaid invoices for immediate cash. The process is faster than most other forms of financing and doesn’t require you to have good credit.
The Bottom Line
Insufficient capital ranks as one of the most common reasons businesses fail. It prevents businesses from purchasing the goods and services needed to maintain and expand their operations. Thankfully, you can raise capital for your business using debt financing, equity financing or other non-traditional lending options such as invoice factoring.
About Universal Funding
Universal Funding is a private funding source that has funded thousands of businesses and more than $2 billion since 1998. We turn your accounts receivable into the funding you need through invoice factoring and can have capital in your hands in a matter of days.