Business Financing - Loans vs. Equity Capital

Read the full article below or at The New-York Times

By AllBusiness.com
February 12, 2008

When it comes to business financing, there are two basic types of funding: debt and equity. A loan for business financing is referred to as debt financing; you borrow money and must pay it back, with interest, within a certain time frame. With business financing via equity funding, you raise money by selling a portion of your ownership in the company.

Debt Based Businesss Financing

Common debt financers include banks, finance companies, credit unions, credit card companies, and private corporations. Taking out a business financing loan allows you to remain in the driver's seat of your own company and not have to answer to investors. Applying for a business financing loan is also usually faster than searching out investors. Professional investors review thousands of investment opportunities each year and only invest in a small fraction.

Another benefit of debt based business financing is that as you pay down your loan you build creditworthiness. This makes you more attractive to lenders and increases your chances of negotiating favorable business financing loan terms in the future.

Overall, debt based business financing is typically cheaper than equity based business financing because you owe only principal, interest, and fees, and retain your full ownership stake in your company.

Equity Based Business Financing

Selling equity means taking on investors and being accountable to them. Many small business owners raise equity by bringing in relatives, friends, colleagues, or customers who hope to see the businesses succeed and get a return on their investment.

Other sources of equity based business financing include venture capitalists, who are professional investors willing to take risks on promising new businesses. These investors include individuals with substantial net worth, corporations, and financial institutions.

Most investors do not expect an immediate return on investment during the first phase of your business; they bank on your being profitable in three to seven years. Equity investors can be passive or active. Passive investors are willing to give you capital but will play little or no part in running the company, while active investors expect to be heavily involved in the company's operations.

Personality conflicts can arise in either arrangement. Before you enter into any agreement with an investor, carefully consider whether or not you are compatible, as this person will own a portion of your business.

Equity based business financing is not cheap: Your investors are entitled to a share of your business's profits indefinitely. Conversely, small business owners who may have difficulty securing a traditional business financing loan or are comfortable sharing control of their business with partners may find equity based business financing a mutually beneficial arrangement.

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