When starting a business, most of the startup costs will be paid by the business owner from savings, retirement accounts, long hours, and hard work. Banks will not lend to start-ups, and those who will do so at incomprehensible rates, and investors will not give money to an unproven business owner. But at some point, after the first few bumpy years have passed, those businesses which succeed will have to make a decision on how to grow.
They can continue to self-fund their growth, accelerating only as fast as their profits will let them, or the can look for cash from a third party to help offset costs to expand. For those businesses which go with the second option, there are two primary ways to do this: with debt, or equity.
Taking on debt through borrowing can be a great option for some companies. The owners do not have to give up any ownership, meaning long-term profits should be higher. And depending on the amount borrowed, the debt could be gone in a matter of years, after which profitability increases. Borrowing is usually a good option if you know exactly what you need to expand, or if you are using the funds to buy a piece of equipment or a building, as you will usually get better rates.
On the flip side, most lenders will require you to sign a personal guarantee, meaning you are on the hook for the total cost of the loans, even if the business fails. And with a loan, monthly payments generally begin immediately, meaning you need to have reserves aside to cover the additional debt cost. So the fear is that if you try to expand too quickly and suddenly can’t cover your overhead, you may not only destroy your business but also put yourself into bankruptcy.
Likewise, taking on an equity partner can have both great and terrifying prospects. An equity partner will give you money in exchange for some percentage of your company. This means you get the resources you need today and may not pay for them for years – there are generally no monthly costs, and also no requirement to ever repay the money. So where the fears associated with borrowing all relate to cash flow and personal liability, that is all solved with equity financing.
This is something I learned the hard way many years ago, this is why when starting my new business, Sterling Heights Limo Service I looked into several types of investors including equity partners. If the business fails, the investors lose their money, but can’t usually come after you. And since you don’t have to repay them over any specific time frame or make payments, there is more flexibility in how you grow. But, the investor may now have a say in how you run your business, which can lead to issues down the line.
Giving up equity can also be penny-wise and pound foolish. If you give up 10% of your business for $300,000, then turn your business into a $10,000,000 company and want to sell, you will have to pay out $1,000,000 to your investor. In addition, he was likely receiving 10% of the profits from the business annually, making that an extremely expensive $300,000.
Another thing to consider with equity financing is what the exit strategy is for the investor. There will generally be a provision of how and when they are repaid for their initial investment. Some will ask for a percentage of profits annually, others will demand a buyout based upon the value of your business in a specified number of years, and still, others will want a combination of the 2.
Ultimately, whether you go with debt or equity is a decision you need to make. If cash flow is your primary concern, then equity financing might make sense. Though it can be far more costly in the long run, it could also save a business from failing during those difficult growth years. But if you don’t have any fears about cash flow or success, then borrowing is usually the way to go, as you can easily cut ties with a lender by repaying the debt. You know what the money borrowed will cost you, but you can never be sure of what you are giving up when you finance with equity.