As the old saying goes, “It takes money to make money.” Many small businesses need financial resources to get their business off the ground. There are two general choices for funding a small business: debt and equity.
When a business takes on debt, it is essentially borrowing funds from a lender, which it will then need to pay back plus interest. When a business utilizes equity, this means it is obtaining funds by selling interest shares.
There are some advantages to choosing debt over equity. If a business takes on debt, the lender generally does not have any equity in the company. Lenders are not granted a share in future profits — they can only receive the amount lent plus interest. This means that the business will not have to share their profits with their lender. Depending on the type of interest taken on with the debt, the amount owed will be known and can be made a part of the business plan. A business may not need to follow the same laws and regulations it would need to follow if it were seeking equity.
However, there are some disadvantages to choosing debt over equity. Debt, unlike equity, eventually needs to be paid back. Also, if interest rates are high and a business is going through a rough patch financially, it could make business growth difficult and could even lead to insolvency. Debt needs to be budgeted for, and there may be a limit on how much can be borrowed. Debt can come with certain restrictions on what the business is able to do. A business may need to secure its debts with collateral, such as company assets. Finally, depending on the type of business formed, the business owners may be personally liable for the debt should it go unpaid.
As this shows, there are advantages both to debt and equity. Those going through the business formation process will need to think carefully about how they want to fund their business. The type of business formed will make a big difference as to what source of funding to tap into, so those looking to start a small business should make sure they understand their options.
Source: FindLaw, “Debt vs. Equity — Advantages and Disadvantages,” accessed March 5, 2018