Financing a Small Business: Loans vs. Equity Investment
You are ready to start your own business, but don't know where to look for financing. You are curious about loans and heard something concerning equity, but this isn't your area of expertise. You are not alone. One of the hardest decisions facing small business owners is how to obtain financing for their business.
Most business owners really have two options: take out a loan or sell a piece of their business for start-up cash. Follow along as FindLaw helps you explore the different options that may be available to you.
Choosing between Loans and Equity
While there are no hard and fast rules, if you are in the formation stage of setting up your business, it makes sense to strongly consider selling an equity stake in your business in order to secure financing to get it off the ground. Equity sales are advantageous because they don't require any repayment, and most businesses don't turn a profit for a significant time period, which makes paying back loans extremely difficult.
If you are an established business and have ongoing financing needs, then loans may make a lot more sense. Loans are easier to deal with when a company has enough cash flow to make repayment realistic, and an established company likely has more collateral to offer to secure the loans. Finally, it's worth noting that loans and equity are treated differently for tax purposes, so consult with a business tax advisor to see if one course of action makes more sense than the other.
Whether you should choose loans or not depends largely on the maturity of your business, cash flow and whether you're simply unwilling to give up any more control in your company.
- Advantages: The biggest advantage for choosing loans is that you maintain control over your business. Unlike equity investors, lenders have no say in your business and are not entitled to your business profits. The only obligation you owe to your lender is to repay the loan as agreed upon. Finally, one last advantage that can be very helpful is that loan payments that go towards paying off the interest on the loan can be deducted as a business expense for tax purposes.
- Disadvantages: The biggest disadvantage of loans is that you have to pay back a steady amount on a consistent schedule, and, as anyone who runs a business knows, profits can be anything but steady. You may have to make a large loan payment precisely when you need the cash for your business the most. Another disadvantage is that many small business owners have to use personal property as collateral to secure the loan, which puts them personally at risk if business goes bad. Finally, if you are unable to pay the loan back, you may be personally sued by the bank, regardless of whether the loan is secured or unsecured.
Equity is a mixed bag of benefit and cost, and the factors that influence whether you choose to use equity sales to fund your business include whether your business is still young or expanding and your willingness to give control over the business to people other than yourself.
- Advantages: Although many may see giving other people an interest in their business as losing control, this doesn't have to be the case. If you choose the right investors, they can be extremely helpful in terms of running the business, establishing business connections and offering valuable advice and assistance. Another advantage of equity investments over loans is that they tend to be far more creative and flexible, which many businesses may prefer. The single biggest advantage of selling equity stakes to investors is that if your business loses money or goes broke, you likely won't have to pay investors a dime.
- Disadvantages: The loss of control in your business is probably the biggest disadvantage involved in selling equity stakes to fund your business. There are many instances where the founders of a business, who put years of their life into the company, are voted out of the company by investors. Be very careful to really consider whether the financing gain is worth the loss of control. The other main disadvantage is that equity investors will want to receive a portion of the business profits, taking away valuable company profits that could otherwise be reinvested into the company. Finally, because equity investors are now co-owners, you have a duty to inform them of all significant business events, and they can now sue you if they feel their rights are being infringed upon.
Using a Lawyer
Let's face it. Financing is one of the most important decisions you can make during the formation of your small business. Speak to a qualified business law attorney now to help decide whether a business loan or an equity sale is right for you.
For more information, see our comprehensive section on Starting a Business.