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Debt vs. Equity: Sources of Venture Capital

Updated on October 27, 2015

Debt to Equity Ratio

Evaluating Your Business Needs

You've completed an objective assessment of the market, found a competitive advantage and determined that your business idea is worth investing the capital you'll need to start your business. Now, you're faced with the challenge of researching all the financial resources available and deciding which one best suits the needs of your business.

When considering all the financial resources, you want to evaluate each option based on its potential cost, and how your potential revenue will measure up against the requirements of a short-term loan or long-term financing. If you're thinking about borrowing funds, first evaluate it for value by making sure a loan is worth the extended obligation you'll have to monthly payments and interest rates. .

You should analyze the different debt financing strategies to see if any can be used to secure funding for your short-term business needs. Home equity loans, SBA loans, a line of credit from a bank, equipment leasing and personal loans from friends or family each all have contingencies that you need to consider before making a decision on any of them.

Where Many Entrepreneurs Go

If you're leaning towards an SBA loan, it's important to remember that they have a very strict criteria. In order to qualify for an SBA loan, you're typically required to put up a substantial amount of collateral. Meanwhile, it could take months of waiting to find out if your loan application was approved.

On the other hand, advantages of an SBA loan is that it provides long-term, below market fixed-rate financing for small businesses. This will cover the costs for construction, renovation land development, and your fixed assets such as the machinery or equipment you'll need to operate your business. Furthermore, an SBA loan has the advantage of borrowing equity at a rate of 10%. When compared to the average 25-30% equity, the value it creates is worth looking into.

Many entrepreneurs try to avoid the legal restrictions of a bank loan, an opt instead to raise the finances they need by asking family members, friends or taking in a business partner. One of the benefits of borrowing money from a family member or a friend is that your loan will be interest-free. This means you'll be under less financial pressure, and there's always that chance that your debt will be forgiven.

The worst part about borrowing money from family or friends is that they often end up wanting a say in how the company will operate. Depending upon how willing you are to allow someone else help you decide the strategy of your business, this still creates the potential for problems which can result in broken relationships and loss of trust. For me, this in itself was enough for me to look elsewhere for investment capital.

provides long-term, below-market, fixed-rate financing to small businesses for construction or renovation of facilities; or to acquire real estate, machinery and equipment

Unforeseeable Circumstances

As entrepreneurs, we like the freedom that comes with operating our own business. We also like having complete control over the company and being the decision maker for our business. This is why many of us decided to go into business for ourselves. For some, giving up control of the company is not an option. However, during the early stages of growth, there may be circumstances that put you in a position where you have to consider an equity financing strategy to secure needed capital keep your business going.

Equity vs Debt

While venture capitalists and angel investor’s work in very similar ways, they both want the same thing out of you and your company. They want a return on their investment and they want to make a profit.

The disadvantage for you is that you'll be forced into giving up full discretion in making business decisions, giving up the controlling interest in your company while sharing ownership rights of your company with an investor.

Equity financing means that you'll give up a share if the company, in exchange for the funding you need to get your business up and running. The advantage being, you won't have any obligation to a monthly loan repayment and you'll have extra working capital that can be used to increase your marketing or production efforts.

Additionally, if you decide to use investment capital to fund your business, typically you'll maintain a low debt-to-equity ratio, which will position your company in a good spot if you ever need to borrow again in the future.

Debt Financing

When considering debt financing, you should be aware of its obligations to monthly payments on the loan principal as well as incurred interest. Unlike equity financing, you'll have to make monthly payments on time, with potential late fees or penalties if you miss a payment. The worse part is that by missing a payment, the lender has the right to cancel the loan, and you stand the risk of losing any collateral you put up to back the loan.

You need to remember that small businesses that are just starting out are not very popular with banks or lending institutions. For the most part, it’s pretty difficult for an entrepreneur who has an unproven record of success to find a bank that will approve debt financing.

Even if the loan gets approved, it’s highly doubtful that the amount will be even close to what you really need. While debt financing is typically less complex and is less expensive over the long-term, it's not worth its reduced flexibility and the minimal infusion of cash it will generate for your company.

Sometimes Using Both is the Best Solution

When you evaluate the various resources to finance you business, both debt financing and equity financing strategies have advantages and disadvantages. Each has its own respective factors that should be considered.

Is loss of full ownership something you're prepared to face? Are loan repayments going to be a burden? Assessing your capital needs and estimating the percentage of funds that you need to borrow is key to deciding if debt financing or equity financing are appropriate sources of funding for your business. In many cases, a healthy combination of both can be the best solution.

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