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Financing a Small Business: Loans vs. Equity Investment

You are ready to start your own small business but don't know where to find startup financing. One of the most complex decisions facing small-business owners is how to obtain financing for their business.

Most business owners have two options: take out a loan or sell a piece of their business for startup cash. This FindLaw article helps you explore the different small business financing options available to entrepreneurs.

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Choosing Between Loans and Equity

If you are in the formation stage of setting up your business, take time to create a business plan. This will help you understand what amount of financing you need in your new business. You can then assess your business credit score and review traditional interest rates for bank loans or credit cards. Knowing your early-stage and short-term expenses will help you make the right decision for your business needs.

Loans

Loans are a form of debt financing. Just as with personal loans, your business repays at an interest rate based on your credit score.

Types of loans:

  • Debt Financing Loan: Like a term loan for a set amount of time
  • Line of Credit: Your business has a set amount it can draw from

Whether you should choose loans or not depends mainly on the maturity of your business, cash flow, and whether you're unwilling to give up any more control in your company.

Loan Advantages

The most significant advantage of choosing loans is that you maintain control over your business. Unlike equity investors, lenders have no say in your business and are not entitled to your startup business profits. The only obligation you owe your lender is to repay the loan as agreed upon. Because your business owes a lender, this is business debt. There is no personal obligation of the individual members to repay the debt unless they give a personal guarantee.

Loan payments that pay off the loan's interest can be deducted as a business expense for tax purposes. Loans are available from traditional financial institutions like banks and credit unions.

You can also apply for a small business loan through the U.S. Small Business Administration (SBA). The SBA loan programs are funding only available to businesses that cannot get traditional financing and meet qualifying criteria.

If you are an established business with ongoing financing needs, loans may make sense. Loans are easier to deal with when a company has enough cash flow to make repayment realistic. An established company likely has more collateral to offer to secure the loans.

Loan Disadvantages

The most significant disadvantage of loans is that you must pay back a steady amount consistently. Anyone who runs a business knows that profits can be anything but constant. You may have to make a large loan payment when you need the cash for your business the most.

Another disadvantage is that many small-business owners must use personal property as collateral to secure the loan. This puts them personally at risk if the business does not succeed. Finally, suppose you are unable to pay the loan back. If the loan amount is not paid or paid on time, then you will have defaulted on your loan. The bank may personally sue you, regardless of whether the loan is secured or unsecured.

Equity Financing

It may make sense to consider selling an equity stake in your business to secure financing to get it off the ground. Equity sales are advantageous because they don't require any repayment in exchange for venture capital. Most companies don't turn a profit for a significant period, which makes paying back loans tough.

Types of equity investors:

  • Small business investment company
  • Venture capital firms
  • Individual venture capitalists
  • Individual angel investors
  • Individuals through online crowdfunding

The age of your business influences whether you choose to use equity sales to fund it. Another factor is your willingness to give control over the business to people other than yourself.

Equity Financing Advantages

Although many may see giving other people an interest in their business as losing control, this doesn't have to be the case. If you choose the right investors, they can:

  • Help run the business
  • Establish business connections
  • Offer valuable advice and assistance

Giving equity capital and choosing equity investments over loans allows you more flexibility. You can be creative with what you offer. The biggest advantage of selling equity stakes to investors is that if your business loses money or goes bankrupt, you likely won't have to pay investors a dime.

Equity Financing Disadvantages

The loss of control in your business is the most significant disadvantage of selling equity stakes to fund your business. There are many instances where investors vote out the founders of a business that put years of their lives into the company. The same can happen to a nonprofit by its board of directors. Consider whether the financing gain is worth the loss of control.

The other main disadvantage is that equity investors want to receive a portion of the business profits. This takes away valuable company profits that could otherwise be reinvested into the company.

Finally, you must inform equity investors of all significant business events because they are now co-owners. These investors can now sue you if they think their rights are infringed upon.

For more information, see our comprehensive section on Starting a Business.

Hoping To Finance Your Business? An Attorney Can Help

Financing is one of the most important decisions you can make when forming your small business. Loans and equity are treated differently for tax purposes, so consult a business tax adviser to see if one course of action makes more sense. Contact a small-business attorney to learn how they can help you get the financing you need.

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