A small business always needs sufficient capital for its day-to-day operations. This money is essential for investing in labor, machinery, and an advance system for managing the workforce. Well, in the domain of small business financing, capital comes from only two mediums namely, lenders (debt) and investors (equity).
Both can provide the required amount for starting or growing a promising business. So, which medium is better? You need to figure out how to provide funds to your business such that it results in good returns. For that, it is essential to compare debt and equity and find out its pros and cons.
Capital from Lenders or Debts
This option is for those who do not wish to sell ownership interests to investors. In debt financing, you borrow money that you finally need to return with interest. Taking a business loan is financing your business with debt.
Pros: The main benefit of this type of investment is that the lender neither has any control over your way of managing the business nor has any share in the resulting profits. The lender only charges you interest for channelizing the money. Additionally, you can reduce the interest paid as a business expense.
For gaining a more profit margin, it is possible to gain a loan with lower interest rate from a family member or friend than from a commercial lender. Doing so also eliminates loan fees that the latter charges. There are many other sources of debt financing such as SBAs, bonds and government programs. However, none is as flexible as friends and family members as lenders in terms negotiable terms of repayment.
Cons: However, by borrowing, you might be incurring a big business expense, which may not be suitable for your small start-up. It can be problematic to repay a big sum each month, especially if you need it for business operations. In case you fail to repay on time, you may end up spoiling your relationship or giving some part of your property.
Capital from Investors or Equities
Here, you have investors such as friends and other individuals or companies to invest in your business and become partial owners rather than lending money. You end up selling shares to them after which they are entitled to share some amount of business profits. So, once the business starts making money, the investors begin to get returns on their investments.
Pros: Equity financing removes the biggest drawbacks of debt financing namely, loan security and restriction on the available cash flow. Further, there is no need to repay right away, which gives enough time for planning and paying business expenses. In case the business fails, there is no one to repay them.
Cons: The investors share a big amount of profits than lenders. Further, it is their legal right to be informed about all major business activities.
Which One is Better for Small Businesses?
It is recommended to go for debt financing if you need cash instantly or just a small sum. Equities take time and that they do not usually come with small amounts. However, equity financing is ideal for a start-up venture, as repayment is based purely on profits. Sources of both types of financing are diverse.
Meet Morakhiya is a personal finance and investment writer from Mumbai, India. He has been investing since he was 15 and has learned a lot through the years. He specializes in creating passive income and financial security through value investing and real estate. To get in contact with Morakhiya, feel free to reach out to him via email at firstname.lastname@example.org. Or via social media: | Twitter | LinkedIn | Facebook | Instagram