Equity Investments vs Loans
Knowing the differences between taking out a loan and bringing in an equity investor are essential to choosing which is right for you.
Small businesses seeking capital basically have two options—finding business loans or securing equity investments. Determining which is better for your business will depend upon the type of business you own, your credit worthiness, and your willingness to have someone looking over your proverbial shoulder.
Advantages of Business Loans
- You maintain complete ownership of your business and remain the only voice in running it.
- The lender doesn't get any portion of your profits or say in the business.
- Managing your finances for loan repayment is easier than accounting for profits with an equity investor. With a loan, you will have regular monthly payments for a fixed period.
- Interest payments can be deducted as a business expense.
- You can use the money from a business loan in any manner you see fit.
- If you need it, repaying a loan is a terrific motivator to working extremely hard for your business to succeed.
Disadvantages of Business Loans
- You have to pay interest on the loan, so you'll be paying back more than you've borrowed.
- If you have poor credit, you may not be able to get a loan.
- You may have to provide collateral on personal property in order to secure the loan.
- Even if the loan is unsecured by personal property, if you default on the loan, you may still be sued personally by the lender.
- If the business fails, you still have to pay back the loan in full, plus interest.
Advantages of Equity Investments
- Investors may be better suited to provide large sums of capital. Banks are leery of lending very large sums because of the risk of default.
- Repayment terms are more flexible than that of business loans.
- Depending on the investor, you may have a built-in mentoring and business advising network to help your business.
- Because they have equity in the business, you have people who are interested in the business succeeding and will help you in this goal.
- If the business fails, you typically don't have to pay back investors (in the absence of any fraud, of course).
Disadvantages of Equity Investments
- You may lose full control over the direction or day to day operations of your business. Investors may want to be part of the board of directors and oversee operations.
- Venture capitalists typically invest in businesses that have the potential to offer huge returns on their investments (i.e., software companies, scientific inventions) and are generally uninterested in most small businesses that don't forecast huge potential growth.
- You may have to share a larger portion of your profits with equity investors.
- Investors retain legal rights with respect to the management of the business and have the right to sue you if these rights are violated.
Venture Capitalists and Angel Investors
Many people hear the term venture capitalists and assume that these investors will be interested in becoming equity investors in their business. However, venture capitalists are like any large investor and are seeking a large return on their investment. Therefore, venture capitalists are uninterested in most small businesses, which generally seek to turn enough of a profit to make a comfortable living for the owner and employees. Unless your business projects huge potential profits (for example, you have a restaurant that you think has potential to be franchised or you have an invention you're working on and need capital for research and development), forget venture capitalists.
What you may be seeking is an "angel" investor. Angel investors (the name comes from an old term describing investors in Broadway productions) also seek a return on their investment, but their goal in investing is sometimes more altruistic. Often, they're wealthy entrepreneurs who want to share their knowledge and help businesses get off the ground.
Information on angel investors isn't as detailed as surveys of venture capitalists or traditional lenders, and it's often difficult to tell the difference between a regular business investor and an angel investor (an angel investor could also be a family member or friend), but according to the Small Business Administration, they are out there, and they are investing in the success of many small businesses.
Choosing Between Business Loans and Equity Investments
Ultimately you will have to determine how the advantages and disadvantages of a business loan and equity investment apply to you and your business. If your business plan projects potentially large growth, equity investors may be attractive for their lenient repayment terms, low risk (they won't sue you unless you defraud them), and business acumen.
On the other hand, if you project modest growth (i.e., you aren't planning on running a large business enterprise) or want complete autonomy in making business decisions, a loan might be better for you.
Whichever option you choose, be sure to carefully contemplate the pros and cons of a loan or equity investment, and you will be able to make a well thought through decision.