When it comes to financing a business, there are two basic types of funding: debt and equity. Loans are debt financing; you borrow money and must pay it back, with interest, within a certain time frame. With equity funding, you raise money by selling a portion of your ownership in the company.
Common debt financers include banks, finance companies, credit unions, credit card companies, and private corporations. Taking out a business loan allows you to remain in the driver’s seat of your own company and not have to answer to investors. Applying for a loan is also usually faster than searching out investors. Professional investors review thousands of investment opportunities each year and only invest in a small fraction.
Another benefit of debt financing is that as you pay down your loan you build creditworthiness. This makes you more attractive to lenders and increases your chances of negotiating favorable loan terms in the future.
Overall, debt financing is typically cheaper than equity financing because you owe only principal, interest, and fees, and retain your full ownership stake in your company.
Selling equity means taking on investors and being accountable to them. Many small business owners raise equity by bringing in relatives, friends, colleagues, or customers who hope to see the businesses succeed and get a return on their investment.
Other sources of equity financing include venture capitalists, who are professional investors willing to take risks on promising new businesses. These investors include individuals with substantial net worth, corporations, and financial institutions.
Most investors do not expect an immediate return on investment during the first phase of your business; they bank on your being profitable in three to seven years. Equity investors can be passive or active. Passive investors are willing to give you capital but will play little or no part in running the company, while active investors expect to be heavily involved in the company’s operations. Personality conflicts can arise in either arrangement. Before you enter into any agreement with an investor, carefully consider whether or not you are compatible, as this person will own a portion of your business.
Equity financing is not cheap: Your investors are entitled to a share of your business’s profits indefinitely. Conversely, small business owners who may have difficulty securing a traditional loan or are comfortable sharing control of their business with partners may find equity financing a mutually beneficial arrangement.