Debt v. Equity Financing

Often debt financing is considered a bad thing, something only businesses that are in trouble take on; a last resort. While debt isn’t always a good idea, we are here to tell you it isn’t always a bad idea either.

Let’s take a look at some terminology…

Debt Financing | We are talking about taking out a loan.  Debt financing is when an individual or organization lends you money that you must pay back (along with that thing we call interest). There are a variety of options when looking for a loan, from a traditional commercial loan to alterative online lending companies.

Equity Financing | Here we’re talking about bringing in a partner. Equity financing is when an individual or organization gives you money in return for an ownership percentage in your company. Again, there are a variety of equity financing options such as individual investors, venture capital, angel investors, etc.

Want more information on the types of funding? Check out our blog: For the Love of Funding.

Let’s take a look at why debt might not be so bad…

Temporary Cash Flow Problems

We aren’t talking about cash flow issues that you expect to last, because debt financing probably won’t help in that case. We are talking about temporary cash flow deficits that occur during the normal course of your business.

For example, let’s say you are a construction company here in North Dakota (where the seasons are winter and construction). During the winter season, business is typically slower and cash is tighter. When the construction season ramps up, you are more than capable of cash flowing your business. In this case, taking on a business loan or line of credit might be a good idea. Not to mention, loan agreements can be structured to allow for seasonal changes in your business. For instance, a loan can call for interest only payments December through May and principle and interest payments the remaining months of the year.

Need another example? Let’s say you work with reimbursement-type grants (meaning you have to spend the money prior to receiving grant funding). At times, this may cause cash shortfalls, even if they are short-term. Again, this is where a line of credit might be a good idea.

You Don’t Want to Give Up Ownership

Bringing on a partner can be a good thing. For example, a partner could bring experience and connections to help grow your business. In addition, a partner is making an investment, therefore you aren’t stricken with loan payments.

However, bringing on a partner can have its disadvantages. Equity investor relationships are much like a parent-child relationship. Parents want their children to make decisions on their own but parents are always in the background, checking in and asking questions. Parents are parents forever.

With debt financing, the relationship only lasts as long as the term on the loan. After that, you are free and clear. In addition, a lender doesn’t have a say in the day-to-day operations of your business (this is of course as long as you are making your payments).

Sometimes, It Just Makes Sense

Let’s say you need a new piece of equipment to be more efficient or take on a new project. With the purchase, you are likely going to either have less cost or more revenue. Ignoring timing difference, this equates to more dollars coming in. As long as those dollars coming in are more than the loan (plus interest), taking on a business loan might make sense.

Speaking of loan payments, if you chose a fixed rate loan (interest rate that is locked), the payments are easier to plan and budget. In addition, even though interest is an added cost to debt financing, it is partially recaptured due to the fact that it is a business expense and therefore tax deductible.

In summary, we understand (and hopefully you do as well) that debt financing is not the answer for every cash flow need. However, in some cases debt is a perfectly good solution. Just as in life, there are pros and cons to most all decisions in business. The key is to understand your business and understand your options so you are able to find the best fit for your future.

 

 

 

 

 

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