Financing a Small Business: Debt vs. Equity

On average, entrepreneurs need about $65,000 to start a business, two-thirds of which comes from personal savings, according to Babson College in Wellesley, Mass. To account for the other third, owners typically can choose between two types of financing: debt or equity.

Which one you decide to pursue will depend on a number of factors, such as your industry, purpose for financing and amount of control you want to retain over your business. Each has its advantages and disadvantages, so understanding which would be a better fit is a good step as you get your business off the ground or move it to the next stage of growth. 

Debt financing
Debt can be a loan, line of credit or bond. It may be a good option as long as you plan to have sufficient cash flow to pay back the principal and interest. The major advantage of debt financing over equity is that you retain full ownership of your business. Plus, interest payments are deductible business expenses, and you’ll build your credit. Because most debt entails scheduled payments, it’s easy to plan around.

But there are some disadvantages. Financing with debt can be more expensive. And those scheduled payments have to be made on time, regardless of your cash flow.

You will need to have a good personal and business credit history to receive debt financing, particularly in the current economic conditions. Lenders generally require a history of cash flow generation or sufficient collateral. Personal guarantees are common on most debt instruments. You should also not have a significant amount of debt already on the books.

Equity financing
You may want to consider equity financing if you have concerns about qualifying for a loan or channeling too much of your profits into the repayment plan. Investors and partners that provide equity financing expect to make a return on their investment, but you aren’t obligated to pay back equity contributors if you don’t turn a profit. No debt payments mean more cash at your disposal.

A disadvantage is that once you have other financial contributors (who each expect a share), you are no longer the full owner of your business. You’ll give up some financial, creative and strategic control.

Equity financing can come from friends, family, colleagues or professional venture capitalists. Angel investors are the largest source of seed and start-up capital for businesses. They tend to fund small businesses for longer periods of time and expect a lower return on investment than venture capital firms. Funding from angel investors amounted to $9.1 billion in the first half of 2009, according to University of New Hampshire's Center for Venture Research.

Creating a mix
Debt and equity capital can work together. Most businesses have a mix of both. How much of each you have will depend on your business. You can check with your industry association to find the average debt-to-equity ratio for your peers or seek advice from your financial advisor.

You can reach Lisa Moyers at 865-766-3052 or by e-mail at lisa.moyers@pnfp.com.