No one wants to be in debt, but sometimes it’s a good idea. That’s right. Borrowing money instead of seeking additional investment capital to finance operations and growth can be healthier for your business.
Let’s examine the investor vs loan options available to find out which is better for your business.
What Are Business Loans?
A loan is when you borrow money from an outside source or an individual and agree to pay it back on a certain schedule with interest.
Pros:
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Loan debt is flexible and terms can be set up to match your specific needs.
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Loans don’t dilute an owner’s equity in the business, and lenders don’t have any claim on the profits of the business.
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This kind of debt won’t have a lasting impact on your company after you’ve repaid the loan.
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Interest on loans is tax deductible.
Cons:
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Loans are fixed obligations that must be repaid, regardless of the financial position of the business.
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Loans raise the break-even point of the business, so you’ll need more sales to reach profitability.
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Loan agreements could impose restrictions on certain business activities and require some assets of the business to be pledged as collateral.
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If the loan has a personal guarantee, owner could face personal losses in the event of default in loan payment.
What Is Investment Capital?
When you raise investment capital from outside parties, you’re giving up partial ownership of the business and a share of future profits.
Pros:
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You don’t have a binding obligation to pay dividends to investors.
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If the business fails, you don’t have to repay the investors.
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You can gain insight from investors who have experience and industry connections.
Cons:
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The business owner must give up a portion of equity in the business.
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Equity costs more than loans because investors assume more risk.
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A business investor may want more control of business management decisions.
Choosing Investor vs Loan Financing
When deciding between investment capital or business loans, you may want to consider how each will impact your debt and equity. As Forbes points out, the key differences between debt and equity are about ownership, control and costs.
Business owners tend to start their own businesses because they want independence and control. They want to own all of it and to enjoy the rewards of their hard work and effort. Why share the profits with an outside business investor when you’ve done all the hard work?
Lenders likely don’t want to be involved in every hiring decision or marketing strategy discussion; their main priority is to be repaid. You can spend more time running your business rather than trying to placate the inevitable questions from investors. Lenders won’t tell you how to run your business.
Debt allows owners keep most of the control, whereas equity takes some control away.
Interest on debt is usually less expensive than the required return on equity. Investors often demand a higher return on their money because they have no guarantees they’ll get their money back. Lenders, on the other hand, often have fixed plans of repayment and less risk since the loans are usually backed up with collateral.
Is Debt the Better Bet?
Lenders offer a variety of different kinds of loans to meet any type of cash flow need that small business owners face. For instance, you can get loans for short-term working capital to finance seasonal increases. And on the other hand, you can get long-term loans to purchase equipment to increase production. With a well-thought-out plan and accurate cash flow projections, you should be able to finance the growth and expansion of your business without ever having to give up any ownership.
After the loan has served its purpose and is paid back, your liability to the lender is over. The lender has no further claim or involvement in your business. When you have investors, they’ll have partial ownership and a voice in your business.
When managed properly, debt can help you keep control and not have to give up any ownership, putting you on the right path to a healthy and profitable business.
