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What Does Equity Financing Mean

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 8 minute read

It’s a common saying that “you gotta spend money to make money.” Although that’s not true in most cases for regular employees, company owners who are trying to get their ventures off the ground will likely find some truth in it.

After all, you have to spend money on things like space, goods, advertising, and human labor. Even if you’re just going to be functioning online, you’ll still need money for things like website design, hosting, and other necessities.

That’s hardly the kind of cash you’d typically find in a savings account. So, the question becomes, “Where do you acquire money to start a business?” Although there are a variety of options for financing a firm, they often require either taking on debt or giving up some kind of stock.

Using Debt to Fund Your Startup

Even if you aren’t familiar with every possible form of credit, you grasp the basics of debt.
Before settling on a specific plan to pay off your company’s debt, it’s in your best interest to weigh all of your available choices. You can take out a personal loan, use your home’s equity, or use your business or personal credit cards in addition to the many other forms of business loans available (including SBA loans).

Likewise, you can borrow money from friends and family if you are willing to risk your friendship or family bond on an unproven business idea. These should be considered before signing any paperwork with any lender, whether it is a bank or a brother.

The Advantages of Debt Financing

There are a lot of positives associated with taking out a loan to finance a business.

  1. You retain complete ownership of your company.

To borrow money is to incur a debt, but you need not hand over any ownership stake in your company.

Maintaining a straightforward relationship with your lender is thus made possible. They may count on a regular payment from you each month for a set period of time. When you’ve paid off your debt to them in full, you’re done dealing with them.

  1. You retain financial and managerial authority.

The fact that you own the company in its entirety means that you get to make all of the decisions. Even more importantly, they have little say over how you should allocate or reinvest your resources.

You have complete leeway in personnel decisions, may dismiss or employ anybody you choose, and can develop and promote your business anyway you see fit. No one will stop you if you decide to change your strategy and take advantage of a fresh opening in the market. No one in the stands can yell at you or tell you what to do; you remain firmly in control.

  1. Methods of Quick and Versatile Financing

Within the next five minutes, you could theoretically acquire a company credit card or receive automatic approval for a loan to fund your small business. And as was just discussed, there are several financial avenues open to you. There are many different ways to obtain financing, from borrowing $200 from a friend to obtaining a $2 million small business administration loan.

  1. The Interest Can Be Deducted

Paying interest on loans is a pain, but you may reduce your taxable income by the amount of the interest you paid.

Additionally, it lowers the real interest rate you’ll pay on any company loans you take out. If you pay taxes at a rate of 24% and can deduct $1,000 in interest payments from your taxable income next year, you will only end up paying $760 in interest.

The Drawbacks of Debt Financing

Obviously, debt is hardly a cause for celebration. There are several negatives that should be considered by business owners.

  1. Cost

Interest on debts is not free, even if they are tax deductible. Monthly loan payments, regardless of how high the interest rate may be, can be a significant drain on resources. Increasing monthly expenditures delays profitability.

Borrowed funds should be used judiciously to expand existing operations. Inexperienced business owners sometimes waste their first funding on unnecessary overhead, such as hiring pricey graphic designers to spruce up their company logo or renting an expensive office space when they could have operated successfully from home. They have no money to pay the benefactor when the time arrives.

  1. You Must Be Eligible for a Loan

You can’t just stroll up to some mystical money machine and withdraw cash. It’s difficult to get a loan unless the lender is convinced that you won’t default on your payments.

Sometimes all it takes to get a loan is asking dad for money, but more often than not you’ll need to show the bank proof of steady income, a solid business plan, and some kind of collateral. Your chances of getting a loan are severely diminished if you have a low credit score, among other things.

If you want to increase your chances of being approved for a loan, you should get serious about repairing your credit and organizing your finances well in advance of needing the funds.

  1. Default Consequences

Lenders don’t often shrug and remark “Oh well, you gave it your best shot!” when a borrower defaults on a loan. Loans are sometimes guaranteed by collateral such as inventory or machinery owned by the borrower. If you fail on a company loan, the lender may go after your personal assets like a home or car.

Equity Financing for Your Business

To a lesser extent than with debt financing, equity financing might be a bit more foreign to inexperienced business owners.

Typically, when a small business owner receives equity funding, they will give up some control of their company in return for money. Among the most well-known types of equity investors are the related but distinct venture capitalists (think “Shark Tank”) and angel investors.

Angel investors, in contrast to traditional VC firms, are often rich people who want to put money into potential startups.

Equally as relevant, crowdsourcing sites have made it possible for businesses to get capital in recent years. Informally or formally, your friends and family may offer to invest in your firm in exchange for an ownership stake through one of these sites. Before agreeing to give up a sizable piece of your company, think about the benefits and drawbacks we’ve outlined.

The Advantages of Equity Financing

Although selling shares in your company may seem risky, it does have certain benefits.

  1. There are no burdensome debt payments.

As we’ve shown, making debt payments every month can seriously damage your company’s ability to produce a profit. Payments are not required on a regular basis when financing is obtained through the sale of shares. Partners anticipate compensation upon the company’s sale to a larger rival or initial public offering.

  1. Partners bring knowledge and connections.

The success of your business is now in the interest of your equity partners. As such, you may expect them to assist you in any way they can.

Investors from both the VC and angel communities often have extensive backgrounds in the same field. By using them, you may avoid the pitfalls that have brought down other businesses in your industry. You benefit from their previous triumphs rather than having to reinvent the wheel from scratch.

They may also provide a group of contacts who can be useful to your endeavors. This might include anything from a simple online search to a more in-depth investigation of potential vendors, suppliers, technical teams, contractors, or even support services like bookkeeping. 

They might even put you in touch with important potential customers. One of the most important factors in determining your professional fortunes is the breadth and quality of your network. An abrupt halt.

  1. Less Recourse If Your Business Fails

In the event of a company failure, venture capitalists and angel investors will not normally foreclose on your property. They won’t submit negative information to credit reporting agencies, either.

But it doesn’t imply they’ll start inviting you over for dinner or give you a glowing reference in the future. But unlike defaulting on a bank loan, the repercussions of failure are generally more manageable.

The Disadvantages of Equity Financing

There are several disadvantages to selling a piece of your firm. Be confident of your comprehension before making any promises.

  1. Future Profits Lost

The success of your business does not guarantee that you will receive all of the proceeds. There is a requirement for cooperation between you and your partners.

Equity partners form a long-term, intricate connection, in contrast to the temporary, straightforward one between borrowers and lenders. Unless one of you buys the other out or the firm is sold, becomes public, or goes bankrupt, you’re trapped working together.

It’s possible you and your spouse will find that you just cannot stand one another. Or that they lack the experience and contacts they claimed to have. Perhaps you feel like they are “meddling,” or that the company’s goal runs counter to your own.

  1. Managerial and financial control are lost

By relinquishing a portion of your business’s ownership, you are effectively relinquishing management of the company. To that end, you and your business partner should talk through any major choices thoroughly.

They may have a very different vision for the company’s future, want to grow into a new sector, or want to stay put in the existing market despite your belief that there are better chances elsewhere.

The way they see fit to invest their money may also differ from your own. They propose investing the majority of your pooled resources on one method of advertising, while you favor another. For better or worse, for richer or worse, you are now officially married.

  1. Slow Initial Fundraising

Waiting for a venture capital company to give you the OK to receive equity money might take months. You’ll need to put on a whole dog-and-pony show, complete with a pitch deck, a business plan, and thorough financials and predictions, merely to make your case for why they should invest and partner with you.

When compared to the bureaucracy of an SBA loan, business loans often move at a far quicker clip.

Bottom Line

This venture launch has been the most challenging endeavor of my life. Harder than my objective of being financially independent within five years of being broke, than raising a kid, and harder than moving abroad and establishing all new acquaintances in my late 30s.

That was money well spent, without a doubt.

As an employee, I’ve never been more devoted to my job. It has pushed me to develop in new ways and provided me with chances I never would have dreamed of.

For instance, while I came into a company with a history in rental property investment, I now invest my money in ways I never would have tried if I had remained an employee. I hope you succeed if you’ve decided that establishing a business is not only your best but your only chance for a happy and successful future. You must now just determine how to cover the cost.

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