ABOUT THE AUTHOR: Caroline Doan is a finance and accounting consultant for NOW CFO. She specializes in assisting clients on complex debt and equity transactions. Caroline has held a number of finance and accounting roles for companies in the technology and distribution industries. She is a former McGladrey/RSM auditor and received her accounting/finance degree from Cal State Fullerton.
Financing Your Business: Debt versus Equity
Nearly every business needs outside financing to effectively operate. Whether it’s to replace old equipment, expand the current business, fund growth, or kick start a new and exciting idea, financing is key to success. Figuring out where to obtain financing is a crucial decision that has long-term implications.
Generally, there are three ways to handle the cash needs of a business:
1. Self-funding from current revenues
If current revenues will not support the growth plans or cash needs of the business, then debt or equity financing will need to be obtained to sustain the business model. Knowing the advantages and disadvantages of debt and equity financing are important to selecting the right source.
Debt and equity financing are inherently different. Debt financing typically involves obtaining a loan from a financial institution that is paid back with interest. There are many types of loans that a business can obtain, but generally this would be the starting point. Equity financing is typically exchanging cash for ownership. In order to determine the most suitable type of financing for a business, the business’s general strategy, its assets and liabilities, as well as long-term goals should be scrutinized in order to come to a proper conclusion.
There are a number of advantages when financing a business through debt. With debt financing, the owners of the business will retain control of the business. The lender, which in most cases, is a financial group or institution, is not generally involved in how the business operates on a day-to-day basis. Once the principal and interest is paid off, business is over and done with between the owner and the financier.
Another advantage of debt financing is that interest related to a business loan is tax-deductible. “You can generally deduct as a business expense all interest you pay or accrue during the tax year on debts related to your trade or business. Interest relates to your trade or business if you use the proceeds of the loan for a trade or business expense. It does not matter what type of property secures the loan.” (Internal Revenue Service, 2016) There are requirements in how capital should be spent in order to qualify for this deduction, but in most instances, the business’s tax liability is decreased.
Debt financing also has some downside. Once a loan is obtained, the business is locked-in and obligated to pay principle and interest payments. Depending on how payments and interest rates are structured, this could make or break a business.
Often, there are upfront debt servicing costs related to obtaining a new source of financing with financial institutions. Companies in the developmental stage with little to no revenue or companies that have limited cash flow must structure their proceeds around paying principal, interest, and debt servicing costs. Debt servicing costs are mostly upfront. Interest is generally spread throughout the term of the loan, but whether the principal is paid monthly, quarterly, and or as a lump sum, this will impact in the business in the long-run.
Liquidity and cash flow are some of the many challenges of running a small business. Additionally, if the business is in its developmental stages, financial institutions consider these types of companies as “high-risk”. It may be very difficult to obtain debt financing without a personal guarantee from the owner(s). If the business is unable to make payments, the financier will seize the business’ assets as well as the owner’(s) personal assets as collateral.
As opposed to debt financing, with equity financing, in most cases, there are no required principal, interest, or debt servicing costs to maintain. Owner(s) are exchanging a piece of their ownership for capital investment. If the business is in its developmental stages or experiencing liquidity issues, this type of financing will not impact the business’ cash flows negatively. There are many types of investors in this realm: friends and family, angel investors, private equity groups, venture capitalists, or even a key client or two will have interest in taking an equity position.
Investors are vested in the business’s growth and success. Depending on the investor, the business not only will gain capital, but guidance on best practices of running the company. This could potentially be positive and assist in the growth of the business in the long-run. Investors can provide additional funding in exchange for more ownership as the needs and operations of the business continues to expand.
As with debt financing, equity financing has some high-potential risks and challenges. Raising equity financing is extremely time consuming. Business owner’s generally have to spend a considerable amount of time in preparing thorough business plans and projections. They also have to devote a lot of face time meeting and interacting with potential investors. This diverts focus away from managing and growing the business.
One of the biggest disadvantages of equity financing is the dilution of both ownership and control the original founder(s) enjoy. Ownership and control of the business decreases as capital increases. Depending on the investor, owners could potentially lose decision-making power related to the direction and operations of the business. In a worst-case scenario, owners/founders can find themselves being exited from the business altogether.
At a minimum, most professional investors will not engage in a transaction if there isn’t a board of directors. These investors will typically require the company to form a board and will also have a seat on the board as a key part of their agreement. Equity investors typically have significant monetary expectations within a given timeframe. If the business owner(s) fails to produce the expected outcome within the time expectation set forth by the investor, then control and future strategy can fall prey to the decisions set forth by the board.
Investors could also potentially be extremely hands-on and highly involved in the day-to-day operations of the business. Even friends & family investors, with minority shares in the business, will expect to “have a say” in the strategy and operations of the company. As the investor becomes a stakeholder in the success and growth of the business, conflicts and disagreements could arise due to varying management styles. It is very difficult to gauge this outcome. Many of these issues don’t arise until after the investment transaction is completed.
Conclusion: The Decision
In order to decide what type of financing is the right fit, it’s important to look at the business’s characteristics as well as its general business strategy. For example, as mentioned before, if the business is in its developmental stage with little to no positive cash flow, debt financing would further strain the business’s cash flow. However, if the business owner is determined to maintain control of the business, equity financing would most likely not be appropriate. Both types of financing have advantages and disadvantages. There is no investment structure that is the perfect fit, just the right fit. Before making a final decision, business owners should factor in all these aspects and determine the best path to reach the business’s short and long-term objectives.
Caroline Doan is a finance and accounting consultant for NOW CFO. She specializes in assisting clients on complex debt and equity transactions. Caroline has held a number of finance and accounting roles for companies in the technology and distribution industries. She is a former McGladrey/RSM auditor and received her accounting/finance degree from Cal State Fullerton.
U.S. Department of the Treasury. Internal Revenue Service. (2016). Publication 535: Business Expenses (Cat. No. 15065Z). Retrieved from https://www.irs.gov/publications/p535/ch04.html#en_US_2016_publink1000243104