Debt and equity are two strong funding options for reaching your business goals, whether the goal is expanding to a new location, acquiring a competitor, or simply opening your doors for your first sale. However, one source of financing may be more advantageous than the other, according to which part of the business growth cycle you’re in. Here are some things to consider as you weigh whether to take out a loan or look for partners to invest in your business.
Debt vs. equity for new businesses
New businesses and startup ventures often need a lot of cash upfront. Entrepreneurs also tend to benefit from the mentorship and advice an equity partner or investor can offer. New businesses with no credit history may struggle to qualify for loans. For these reasons, equity funding is often the best option for getting the capital you need to grow.
“Equity financing may be necessary if you can’t qualify for a startup business loan and want to avoid more expensive options like credit cards. Just make sure the investment is a fair valuation since your business is young,” wrote NerdWallet.
The downside to equity funding is that you will be giving up an ownership stake in your business. Most lenders require at least two years of financial history and a credit score of at least 550, according to Bankrate. A sole proprietor may be able to meet this standard and qualify for a loan, which allows you to retain full control of your business.
[Read more: What Is Business Equity?]
Debt vs. equity for mid-growth businesses
When your cash flow is more predictable, debt becomes a more viable option for funding your business needs. Taking on debt responsibly allows you to start building business credit, which can help you get better vendor payment terms and lower insurance rates.
“Debt financing may have more long-term financial benefits than equity financing. With equity financing, investors will be entitled to profits, and if you sell the company, they’ll get some of the proceeds too,” wrote NerdWallet.
There are also many different ways to take on debt. Debt isn’t limited to a bank loan; there’s also lines of credit, business credit cards, invoice financing, cash advances, and SBA loans, among other options. The diversity of debt financing can help you manage risk and retain full ownership of your company while still getting the cash you need.
For larger, more mature companies, debt generally far outweighs equity in terms of benefits.
Equitise
Mid-growth companies still face a fair amount of risk, however. If you’re still staking a foothold in your marketplace, equity may be the better option. You won’t have the pressure of making loan repayments while managing uneven cash flow or have the risk of defaulting on your loan impacting your decision-making.
“If your business experiences drastic cash flow fluctuations from month to month, debt financing can be risky,” said Nav.
It’s also worth considering that debt and equity have different tax implications. Loan interest and fees are considered tax deductible in most cases. Your business structure determines how you will be taxed on equity funding.
[Read more: How to Invest in a Business]
Debt vs. equity for mature businesses
When your business is generating profit consistently and growing sustainably, the sky’s the limit. Equity can be a good way to start laying the groundwork for succession planning or to divest your ownership at a healthy profit.
Most mature businesses use debt to finance operational needs. “For larger, more mature companies, debt generally far outweighs equity in terms of benefits,” wrote Equitise. “This is partly known as the debt tax shield benefit where leveraging through debt can allow a company to enjoy additional tax benefits alongside company growth.”
Many businesses never choose between one or the other and instead leverage both to meet different needs. There’s a time and a place for both equity and debt financing for your business. Make sure you’re balancing risk with opportunity when you consider your next financing decision.
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