Funding Your Business: Loan or Equity Financing?
Need funds to get your business idea off the ground or an extra capital take your business to the next level of growth? There are generally two main types of funding sources that you can utilise: business loan and equity financing.
Both financing options allow you to get funds for business activities, but the nature of their funding arrangements are different. They also impact your business differently.
To help you decide which funding is ideal for your business, here’s a comparison of the two.
Business Loan or Debt Financing for Business
A business loan involves borrowing money from a lender and repaying it in full with interest within an agreed period. Depending on the conditions and requirements of the loan, there will be consequences for not being able to complete the loan repayment over the specified period, including repossession, foreclosure and reduced access to future financing.
Types of Business Loans
Business loans have different types according to specific business needs, including:
- Business Term Loan. Usually offered by large financial institutions like banks, it enables you to borrow a large lump sum amount upfront.
- Small Business Loan. Typically offered by fintech companies for startup and small business owners, it allows you to borrow a limited amount of funds with fewer document requirements.
- Merchant Cash Advance. Ideal for businesses whose revenue mainly comes from credit card transactions, it gives you access to a lump sum of capital, which you repay with interest through a set percentage of your future daily credit card sales.
- Invoice Financing. You borrow money from a lender and pledge your unpaid invoices as collateral for the loan.
- Equipment Loan. You get funds to buy business equipment or machinery and typically offer your purchased equipment as collateral for the loan.
Advantages of Business Loan
Funding your business with a loan offers many benefits, including:
1. Full Ownership of Your Business
Borrowing money from a lender doesn’t give them any right to your business. You simply pay the principal amount, interest and associated fees but you’re in control of you how you spend the money you loaned. You keep the full ownership of your business from the start of your loan to the end.
Just make sure to pay your dues on time and complete the loan within the agreed term. Otherwise, your business property can be repossessed and sold by the lender if you default on your loan.
2. Builds Your Business’ Credit Score
Your repayment activities are reported by your lender to the credit bureaus. If you make monthly on-time payments and eventually complete your loan obligation within its agreed term, it will be reflected in your credit report. It tells lenders that you can be trusted.
Your credit score will also improve. Payment history is the biggest factor that affects your credit score, making up to 35% of your score. If you score high in this criterion, you’ll likely have an overall high credit score.
3. Promotes Business Growth
You will never get ahead in the industry with a cash-trapped business venture. A low-interest, long-term business loan helps you get the sufficient working capital you need to keep your business running smoothly and profitably.
It allows you to buy the inventory or equipment that increases your workplace productivity and efficiency, pay for additional employees that supports a smoother business operation or make effective marketing and advertising campaigns that attract, engage and convert more customers and boost your return of investment.
4. Tax Deductions
While the principal business loan payment is not tax-deductible in Australia, the interest payment is. These include the interest accrued on the loan that’s not paid by June 30 (end of the financial year) and the interest that you as a business owner accrued from any personal loan.
5. Faster Funding
It is generally faster to secure debt financing for your business than search for investors to start your new business or keep it afloat or thriving in the fiercely competitive start-up ecosystem. Professional investors typically receive and review many investment opportunity proposals but only invest in a few.
Disadvantages of Business Loans
1. Repayment Can Be Difficult
Any business loan needs to repaid with interest within the agreed term. This won’t be a problem if your business is profitable and has a strong cash flow. However, if you’re still struggling to keep your business afloat despite the extra funds you get from the loan, you might have a hard time keeping up with the monthly repayments. The last you would want is giving all profit to debt repayment.
2. Tough to Qualify
It’s not easy to qualify for a business loan, especially a standard business term loan. Typically, your business needs to be established at least for a couple of years and is earning great revenue. It must also have a good credit score and own valuable assets to be pledged as collateral. If you don’t have these requirements but is approved for a loan, you’re likely to pay high interest for it. Spending lots of money for your loan repayment may not be a smart business move.
3. Risk of Repossession, Bankruptcy or Foreclosure
Most business loans are secured with collateral or require a lien on the property. This means that if you fail to repay the loan on the agreed timeframe, the lender can seize your business property or assets. Any record of repossession, bankruptcy or foreclosure also damages your credit profile severely, disabling you to secure favourable financing in the future.
Equity Financing for Business
Equity finance is when you get funds to support your business projects from shareholders or investors in exchanging for them owning a part of your business. You will not need to return or repay the funds. However, your shareholders or investors will gain returns from the profit your business makes.
Sources of Equity Financing
There many ways investors to secure equity funding from, but the most common include:
- Private Investor. Any individual who invests their own money in your business in return for a share of your business profits; Includes your family members and friends
- Angel Investor. A wealthy individual who can fund between $25,000 to 500,000 to help a startup or small business take off the ground or thrive in its industry
- Institutional Investor. A company that’s eager to invest large sums of money, such as banks and insurance firms
- Venture Capitalist. A person or company that provides funds for a promising startup that has a high potential for growth but is also a high risk; Majority of venture capitalists belong to professionally managed public or private firms and usually invest in business sectors, like IT and bio-pharmaceuticals
- Stock Market Investor. An individual who buys a share of your business in the stock market
Pros of Equity Funding
1. No Debt to Be Repaid
Unlike a business loan, equity funding won’t tie up your profit to loan repayment. You won’t have to worry about making on-time monthly repayments for the loan and its interest. You will have more profits to save or to fund other business needs, like buying a piece of equipment or hiring additional staff.
2. No Risk of Bankruptcy, Foreclosure or Repossession
You don’t have to deal with a lien on your business or pledge your business equipment or vehicle to secure financing. Even if your business fails, nothing will be repossessed or taken away by lenders. You also don’t need to pay back your investors.
3. A Network of Business Contacts
Your investors not only provide the money to get your business projects running smoothly and without delays, but they can also give you insights and advise that can help your business grow, manage risk and rise above the competition. With the right network of shareholders, you’ll gain wisdom and build strong connections that can last a lifetime.
4. More Funding
As your business grows, your investors may provide follow-up funding to finance more business projects, like offering more products and services, expansion in other locations and new sales and delivery channels to tap.
Cons of Equity Funding
1. May Take Some Time to Get the Funds
It can take you a long time to get funds from an investor than borrowing money from a lender. First, you will need time to research or look for the right investors for your business projects. When you do, you typically need to create a business plan to be presented to these potential investors. The investors may also require more time to review your business plan before making a decision.
2. Shared Ownership of Your Business
Your investors do not only have a share in your business profits. They also have a share in the business decisions and you will need to consult with them over the direction of your company. This won’t be a problem if you and your shareholders have a consensus agreement on all business matters.
Unfortunately, this rarely happens because your investors typically have different business ideas and interest. If your investors are strong-willed and defiant about their decisions, you might lose control of your company. Sometimes, this could end up with you abandoning your own business.
3. Risk of Strained Relationship
When your source of equity funds are your family members and friends, you are not just putting your business ownership on the line but also your good relationship with them. Even if you are personally close with them, your business ideas, especially about the direction of your business, might differ. This can turn into a disagreement that, if not resolved, puts an end to friendship or family bonds.
Another situation that puts your relationship with your investors at risk is a business failure. The stressful situation often tears down relationship and trust, which sometimes lead to disputes and legal battle.
Choosing between a business loan and equity financing to fund your business projects can be confusing. If you’re having trouble, ask yourself the following questions before deciding:
- How much financing do you need?
- How soon do you need the money?
- Are you okay with sharing your business ownership with other people?
- Are you looking for more than just money, like industry network and experienced partners?
- How big do you want your business to be in terms of profits and staff?