Small business financing can be divided into two broad categories: debt and equity financing. Both can provide the capital you need to grow your business, but they work in very different ways. Familiarizing yourself with how debt and equity financing compare is an important step if you're preparing to seek out funding.
What Is Debt Financing?
Debt financing simply means borrowing the money you need from a bank or another lender, with the agreement that you'll repay it over time. Examples of debt financing include:
- Business lines of credit
- Small business credit cards
- Invoice, inventory and equipment financing
- Merchant cash advances
- Term loans
Each of these financing options is designed to serve different purposes. A term loan, for example, could be useful for fueling your growth goals, while a merchant cash advance or small business credit card may be a better fit for solving short-term cash flow gaps.
Depending on the type of financing involved, you may or may not be expected to provide collateral. If collateral isn't necessary, the lender may require you to offer a personal guarantee or agree to a Uniform Commercial Code (UCC) lien on your business assets. The loan terms, including the interest rate, fees and repayment period, would be set by the lender.
What Is Equity Financing?
Equity financing involves an exchange of sorts, in the sense that you're selling a piece of ownership in your business. In this scenario, your small business receives capital from individual and/or institutional investors. That may include angel investors, friends or family members, venture capitalists or private equity firms. In return, the investors receive a stake in your business.
Generally, you aren't expected to make regular payments with equity financing. Instead, you repay your investors a share of your business profits at some point in the future. If your business doesn't become profitable, you aren't responsible for repaying anything. Equity financing is most often associated with startups and early-stage businesses that aren't generating a profit yet.
How Debt and Equity Compare
Debt and equity financing both have some advantages and disadvantages. With equity financing, for example, it's possible to get funding without having a lengthy operating history or even being profitable. For newer businesses, getting debt financing without some kind of track record is no small feat.
On the other hand, you're handing over a share of your future profits when you agree to equity financing. In some instances, your investors may want to take a hands-on role in the management of your business. That's not an issue when you're taking out a loan or line of credit from a bank or an alternative lender. If you're not comfortable giving someone else a say in how you run your business, then equity financing may not be the best choice.
If you're leaning more towards debt financing, the next step is deciding which type of debt will work best for you. Term loans can be an effective way to achieve your goals. In the next part of our series, we'll dive into the details of how they work.
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