Co-founder/partner in Lendzi.
As a small business owner, you should never borrow more money than you need. Debt can be a constant burden on your company’s cash flow, and unless you have the capital set aside or can generate the necessary profits, you may face problems when that debt comes due. As a co-founder of a lending company, I believe there are many ways that debt can be better than equity financing, where you will have to sell part of your business to an investor to generate funds. These are the ways debt can help your business more than equity financing.
You are in control
The primary advantage that debt offers over equity is that you won’t have to hand over part of your actual business to another person. Even if you sell just 10% or so of your business, you’ll be giving up complete control of your company and likely never getting it back. This can divert your business from its original vision or, at worst, stifle its growth. While equity financing doesn’t drain your cash flow—and provides you with a cash injection—the downside risk is something that many companies don’t like.
It can be a short-term liability
While debt financing usually lasts only a few days, equity financing lasts forever. Unless you buy out your investors at some point, their ownership of part of your company will never go away. This can be a big lifetime cost for a one-time cash injection. Before you decide on equity, sit down with your tax and financial advisors and make sure the exchange is really in the best interest of your company.
Debt can generate income
When you borrow money, you can use that loan to hire additional workers, expand your plant, or produce more inventory. The income you generate from these activities can be used to both pay off debt and generate profits that your business can retain. But if you have equity partners, you will have to share some of that profit with them. In addition, since equity financing is a one-time injection, you will have to return to the capital markets again if you need additional funds in the future. If you continue to sell the company’s equity to generate funds, you will have to share even more of your profits with your investors.
You can build your financial history
An injection of investment capital does nothing to build your business credit history. However, a business loan that you repay on time can significantly increase your score. This can lead to lower interest rates on future loans you might take out. Your credit rating can continue to grow with each loan, a benefit that can literally save you thousands of dollars over time.
The debt can be refinanced
Even if you have to take out a loan in a high-rate environment, you can potentially refinance that loan at higher rates in the future. In other words, if rates rise, you’ll benefit from the low interest rate you have now, but if rates fall, you can switch and take advantage of lower financing costs. Depending on the size of your loan—and the interest rate environment—you could potentially save thousands of dollars a year in financing costs, which you can then allocate to additional staff, products or general corporate needs. If you instead sell part of your company in the form of equity financing, you will never be able to recoup what you lost or benefit from the changing economic environment.
What you need to know before borrowing
Before your company takes on debt, you need to know a few things:
• What is the total cost of debt?
• Will it affect your personal credit?
• How long will the debt repayment take?
• Are there penalties for debt repayment or refinancing?
• How much money do you really need to borrow?
All these questions are primarily related to the mathematics of borrowing. While you may think you need to borrow $20,000 to buy new equipment, you’ll need to understand whether you’ll have the ongoing cash flow to pay off that debt and whether you’ll need additional cash for things like maintenance, servicing, or even marketing. You should also explore the consequences of not being able to make payments—especially if you may be personally liable.
Debt is not something to fear, but it must be managed. While debt provides funds that can be used for expansion and growth, it also creates an additional obligation that we must commit to, even in bad economic times. Debt-based expansion may seem like an easy and obvious choice when business is booming, but things can change if the economy falls into recession. A drop in sales can reduce your cash flow, making debt service more difficult.
To avoid these problems, make an action plan before you go into debt. Be able to answer all of the above questions and consider speaking with a personal loan specialist if necessary. Borrow only what you need, leave a buffer in your cash reserves, and have an exit strategy in case economic conditions tighten.
The bottom line
Debt and equity financing are two common ways companies raise money, and both have strengths and weaknesses. Equity financing, for example, does not deplete your company’s cash flow. Although it dilutes the existing owners, it does not require payment of interest or principal. This not only frees up capital to reinvest in the business, but also brings cash to corporate coffers.
But if you want to increase your funding, retain full control of your company and have flexibility for the future, borrowing money can often make more sense than selling part of your company. Talking to a personal loan specialist can also help if you’re looking for a customized financing solution that will best suit your company’s needs.
The information provided here is not investment, tax or financial advice. You should consult an authorized professional for advice regarding your specific situation.
The Forbes Business Council is the premier growth and networking organization for business owners and leaders. do I qualify?