Raising Capital vs. Raising Debt

When SMB owners seek funding to expand their companies, there are two main routes available: debt and equity. Before you choose a source of funding for your business, it’s critical to understand the differences between these two options and the pros and cons of each. In this article, we’ll explore the key differences between funding a business via debt and via equity and how to select the best option for your specific situation. Whichever route you choose, you’ll need a sound well-reasoned business plan as well as meticulous financial records that show your business is financially stable with a solid operational and earnings history as well as future growth potential.

Equity Financing

Equity financing involves trading an ownership stake in your business for capital. Equity financing can come from a variety of sources.

Personal Assets

Some business owners choose to tap into their own assets, such as retirement savings, to fund expansion. While this can be a straightforward way to secure funding, it puts personal assets directly at risk. Financial advisors often encourage exploring other funding sources first to avoid relying solely on personal capital, especially if you don’t have sufficient reserves. However, if other options aren't available, this may be a viable way to get started.

Friends and Family

Soliciting equity funding from friends and family can also seem like an attractive option. Business owners can often access funding more easily and receive more flexible terms when working with people who are already in their support network. However, these resources are typically much more limited than those of other types of investors, and they may not be sufficient to make a significant impact on your business. Additionally, putting friends’ and family members’ assets at risk can be equally—if not more—problematic than risking your own savings. If your plans don’t pan out as anticipated, equity financing from friends and family could put serious strain on your relationships.

Angel Investors

Angel investors are high-net-worth individuals or groups who provide capital to startups and small businesses. Often, they are former entrepreneurs or executives who have personal wealth and a keen interest in supporting budding enterprises. Known for investing in early-stage companies with high growth potential, angel investors are typically willing to take on higher levels of risk compared to traditional lenders or venture capital (VC) firms. They might perform less due diligence than these entities before funding a business and exert less control over the company once they’ve invested in it.

Venture Capital Firms

VC firms are composed of professional investors who manage pooled funds from various sources, including institutional investors, wealthy individuals, and even pension funds. VC firms can generally offer larger amounts of funding than angel investors, and they often demand a larger stake in the business in exchange for their investment and may exert more control over the business and its operations. For example, it’s not unusual for a VC firm to make management changes if the business is underachieving. They conduct extensive due diligence before investing in a business. A VC firm will delve deeply into a company’s business model, financials, and operating history as well as their products or services, market, and management.

Private Equity Firms

Sometimes, SMBs can access funding via private equity (PE) firms. However, these firms typically invest in more mature businesses that have a history of profitability and operational success rather than startups. PE firms can deploy large amounts of capital and tend to take a hands-on approach and control over business operations, working closely with management teams to implement strategic, operational, and financial improvements to bolster the company’s chances of success.

Requirements for Accessing Equity Financing

Although different sources of equity financing require different levels of documentation, they all seek assurance that your business is sound and that the funding is likely to fuel growth. To access any type of equity financing, you should keep good financial records, be prepared to demonstrate that your business has a solid operating history, and have a sound business plan that shows the company’s value proposition, its total addressable market, and how the funds will be used to generate profit.

Advantages of Equity Financing

Equity financing has some distinct advantages. This route offers greater flexibility than debt financing because there is no requirement to repay the funds. Instead, your investors share the risk of loss as well as the potential for profit. Additionally, angel investors, venture capitalists, and private equity firms typically have considerable business expertise and connections that can be of tremendous benefit to the growing business.

Disadvantages of Equity Financing

While the advantages of equity financing can seem compelling, its disadvantages can be significant. Anytime you grant others equity in your business, you dilute your ownership stake. If outside investors provide large amounts of capital, they may exert unwanted influence over the company’s management and direction. Equity investors also expect substantial returns for their investment, either through dividends or increased share value, which are typically higher than the interest payments for a loan of the same amount. Depending on the structure and percentage equity ownership, equity investors may hold a controlling stake or exert significant influence on the business, its operations, management team, and key resources. As a result, financing growth through equity can end up being far more costly than funding with debt. For example, if your business is growing at 20% per year and you can borrow money at 12% or 14% per year, debt financing is generally a more cost-effective option, all other factors are equal.

Debt Financing

In contrast to equity financing, debt financing refers to taking out loans to fund business activities. There are a few different sources SMBs can explore for business loans.

Traditional Banks

Traditional banks are a common source of debt financing. To issue a business loan, banks generally require at least a two-year operating history and strong annual revenue. The interest rate offered will depend on the amount of the loan, the length of the repayment term, and the credit score of the business and/or its owner. Depending on the size of the business, many banks also require a personal guarantee from the owner, which leaves them personally responsible for the debt in the event the business is unable to pay it back. In short, the interest rate may be better than other debt alternatives, but the requirement of a personal guarantee could lead to adverse conditions if things don’t work out as planned.

Small Business Administration

Small Business Administration (SBA) loans come with specific requirements that don’t apply to other types of funding. These include criteria related to business size, industry classification, and the inability to access other sources of credit. However, these loans are available to businesses and owners with lower credit ratings than most other lenders would accept, making them a valuable resource for many small businesses. In addition to funding, SBA loans offer other benefits such as access to business counseling and educational resources. It’s important to note, though, that SBA loans typically require a personal guarantee as well.

Private Lenders/Credit

Private lenders include high net worth individuals and finance companies, and PE firms often have private credit funds available for businesses. However, loans from these sources often come at higher costs than banks or SBA loans. Not only do private lenders generally charge higher interest rates, but their loan terms often contain restrictive covenants that can pose risks to the business. For example, if a debtor business fails to meet specified earnings targets, a private lender could call the loan due in full before its term expiration. Also, from time-to-time, a private lender may ask for an “equity kicker” to enhance their returns and to lower the interest rate. As a result, a private lender may become a minority owner in your business.

Advantages of Debt Financing

When seeking funding, many business owners first look to equity financing. However, debt financing can offer important advantages over selling shares of your company. Taking out a loan to fund growth allows you to retain full ownership and control of your business—and its profits. While there is no limit to the amount of profit you could forfeit as a result of equity financing, loan payments are fixed and predictable (as long as there are no covenants like the one mentioned above), and the interest you pay is tax deductible as a business expense.

Disadvantages of Debt Financing

Of course, any source of debt financing comes at a cost. Unlike money raised through investors, you will need to repay a business loan. A company’s creditor has a contractual claim on its income and assets, and it must be paid before profits are distributed to owners. If you’re required to put up collateral to secure your loan, that property could be lost in case of default. If the loan is unsecured, then the creditor could lay claim to your personal assets to satisfy payment requirements. With debt financing, the business and its owners take on the full risk of default, which can impact personal as well as business credit scores. It should be noted that at times debt providers will ask for a board position and may influence business decisions. On the other hand, if you fund your business with equity, your investors are paid only when there is profit to share.

Reporting Requirements and Additional Considerations

If you don’t already have strong financial management processes in place, it’s important to get started as soon as possible. Your financial management strategy should be tailored to meet the specific needs of your business, providing the insight you need to steer the ship while allowing your team to remain focused on core operations.

Professional Guidance on Funding Your Business

Before choosing a funding option for your business, it’s important to seek advice from an experienced financial professional. They can help you explore all available options and guide you toward a solution that aligns with your needs, resources, and goals. Additionally, before pursuing funding options, it’s critical to ensure your finances and infrastructure are in good shape. Businesses with a solid financial and operational infrastructure often achieve higher valuations. A significant part of this preparation is tracking Key Performance Indicators (KPIs) which are important benchmarks for managing your business. These may include metrics like cash flow analysis, collection timelines, billing frequency, and industry-specific indicators.

Stable Rock has been the bedrock for SMBs in a variety of industries for nearly half a century. We specialize in providing experienced financial and operational support for our clients, including advisory, outsourced CFO, accounting, and strategic finance and reporting services. If you’re exploring funding sources for your business, our team of trusted experts can help.