The choice between investors versus loans is easy when your new business can’t qualify for a small business loan but investors will take a chance on your idea, or when your business can take advantage of a decades-low interest rate for new equipment purchases instead of using cash on hand.
However, the answer is rarely so clear-cut, or maybe a combination of both could work. That’s where this article comes in. Below, you’ll find scenarios for when one is better than the other. You’ll learn the pros and cons of each financing option to help you feel confident that you’re making the right decision when either investors or a business loan could make sense.
Here’s the breakdown. In our first section, we’ll cover when to choose an investor over a business loan. Then, we’ll go into when business loans make more sense than an investor. Finally, you’ll learn when you may want to do a combination of equity and debt financing.
Investor Funding and When It’s Better
Investors provide funding because they are buying ownership in your business and expect a return on their investment from a share of future profits. Using this strategy has these pros and cons:
Pros:
- No obligation to pay back even if you lose money
- Provide funding for any business stage and bring their own expertise
- No collateral required
- Access to their network of professionals who can provide advice and strategy when needed
Cons
- Give up a share of future profits
- Investors may influence decisions
- No benefit to your business credit score
- Reporting to a third party versus being able to make all decisions without signoffs
Investors share the risk and you don’t have to pay them back even if the business fails completely. This means investors will want to influence decision-making in the business and you’ll have to share future profits with them, whereas lenders won’t try to control the business as long as you make on-time payments and stay within the terms of the loan agreement.
An investor wanting control in your business isn’t always a bad thing though. They can:
- Provide business expertise to help you grow
- Provide introductions to new customers
- Help you navigate expansion markets and unfamiliar government regulations
An experienced investor can even help you qualify for future loans by giving lenders more confidence that you can execute a business plan.
This makes investors a better option when you can’t get approved for a loan, when the loan would cost too much due to interest rates, or when there is a higher level of risk involved with the business. There is no shortage of situations where a lender may think you’re too high risk to lend to but an investor may be open to financing your company, including:
- Funding a new business or one that is struggling so long as they see an opportunity for success
- When you need money but have too much debt or no collateral
New business with an unstable financial history
Investor financing is better than loans for new businesses or when you have a poor financial history because investors put money in expecting profits at some point in the future, whereas lenders want you to start paying back the loan immediately. If lenders think you’re a higher-risk borrower, they’ll charge higher interest rates, making the loan cost more, or they will decline your application.
For new businesses or big changes to your business model, investors are better than loans because they may be willing to take a chance on an unproven model or the promise of an idea becoming successful.
Too much existing debt or limited collateral
Lenders are not the right choice when you have too much existing debt as you become a riskier borrower even if you can afford new monthly payments. If you do get the loan, the interest payments could be higher because your risk level is high. You may also need to make a larger deposit, which depletes your cash on hand. Investors are better in this case because they will ride through any downturn or debt situation in exchange for their share of the profits when things recover.
Exactly how much debt is too much depends on the lender and the characteristics unique to your company. If you are unsure, start by calculating your debt ratios for your business and then ask the lenders you’re applying with about how your ratios compare to other borrowers.
Investors are also better than lenders when you have little or no collateral because investors do not require collateral like a lender does. If you’re not able to provide collateral to a lender, you’ll have a low chance of being approved for a loan, the loan amount will be too low, or the interest rate will be too high.
High-risk ventures and expertise needed
High-risk business ventures, especially where an investor’s expertise will help you succeed, make equity financing preferable to loans since you are sharing the risk with the investor and do not have to pay anything back if the idea fails.
The investor will be there to troubleshoot situations they have likely been through before or they can bring in an expert to help you succeed. Here are examples of common high-risk business cases where investor money is likely better than a business loan:
- New market expansion
- New product lines or services requiring separate production facilities and processes
- Startup businesses in high competition industries or new niches
- Buying a failing business and trying to turn it around
- Consolidating multiple struggling businesses to make a bigger and more successful one
Benefits of Loans Over Investors
The main benefit of loans over investors is that you keep total control and ownership of your company. Because you control the company, you get to make decisions on how operations should work and which risks are worth taking, and you do not need to get approvals from a third party, which would be required when working with investors.
On top of these benefits, you keep all profits minus the principal and interest payments during the term of the loan. Meanwhile, with investor financing, you’d have to pay the investors as your company turns a profit.
Business loans have these pros and cons when compared to using investor financing:
Pros
- You don’t dilute your ownership or profit.
- There may be tax-deductible interest.
- Depending on the lender, you could build your business credit score if the loan is reported to the credit bureaus and you make on-time payments.
Cons
- You must pay back the loan regardless of success or failure.
- Defaulting on payments can hurt your business credit score, and a hard inquiry causes a temporary decline.
- Loans can indirectly restrict other investments you want to make.
When you have stable cash flows and defaulting isn’t a risk, regular loan payments should be doable. For one, you may be able to build your business credit score. Also, you may be able to write off the interest paid to lower your tax bill. Neither of these happens with investor financing.
Investors can limit how you use funding because they control some of the decision-making, but with a business loan, you can have more flexibility, whether you get a general loan or a specific type like equipment financing or working capital loans.
Because you get to keep all of the future profits after paying down the loan, you may hit your financial goals faster because you don’t have to pay investors. If you plan on selling and exiting, you get to do it on your terms rather than having to hope the investors do not stop the process. Both of these scenarios could make business loans the better option.
Low risk to cash flows and future profit
When there’s a low risk to your cash flow and future profits look like they’ll be strong, business loans are better than investors because you keep full control of the business and you keep all the profit.
By using loans and making regular, on-time payments, you could take advantage of better rates in the future. This can also result in being approved for higher loan amounts with less restrictions. Combined, this could result in higher growth, lower interest payments, and more profit for your business.
New asset purchases
Loans are a better choice than investors when purchasing new assets that improve productivity because the combination of more revenue from higher output, cost-cutting from production efficiency, and new depreciation and interest deductions leads to higher profits that you don’t have to share with investors.
There is an exception, though. If you are in a highly competitive or fragmented industry where customers can easily substitute your business for different vendors, investors may have the foresight to stop the overproduction and prevent you from having to liquidate the goods or take the loss. They have the industry experience to detect the trends and stop the issue before it starts.
Exit plan
When selling the business is your exit plan, using loans over private investors lets you keep full ownership, so you don’t dilute your eventual windfall or have them add red tape. You’ll be able to grow the business towards your vision and the sell price that makes you happy without worrying about satisfying the whims of other owners.
Other times, investors may push you to sell when you’re not ready. If you go with a business loan versus giving up ownership with equity financing, you can sell the business when you see fit as long as the loans are paid off.
When Both Options Make Sense
If you want to grow and scale fast, a combination of business loans and equity investors may be a good option as the investors can get you cash flow to fund long-term goals and provide you with strategy, while a short-term business loan can help with current needs and short-term investments.
If you’re acquiring a failing business to increase your footprint, and it needs to be upgraded, the lender may see the acquisition as a risk, whereas investors may see it as an opportunity. Once you’ve acquired the business with the investor’s financing, you can take a loan to cover the cost of upgrades, renovations, and repairs.
When your business needs funding for any reason, you’ll make the right choice by weighing the pros and cons of equity investor financing versus a business loan. By listing your short-term and long-term goals along with how the financing will be used, the answer becomes clear.
National Funding does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
