Business Plan Center

Know your options: Debt or equity business financing

Find the right funding for you — from credit cards and venture capital to business startup loans.

Published: April 24, 2015

It may come as no surprise to you that capital is the key to moving a business from concept to reality. For new ventures, an initial investment from a business startup loan, a microlender, Opportunity Finance Network (OFN), or an equity sale can be used to purchase equipment, inventory, or raw materials. An existing business might need such funds to expand production or enter new markets.

Wherever you are in the business lifecycle, you have a variety of funding options that fall into two categories: debt financing and equity financing.

Debt financing

Debt financing allows you to borrow money and repay it with interest. In other words, debt financing means receiving a loan. While loan payments can cut into your cash flow, they don't affect your business's ownership structure.

Sources of debt financing include:

  • Friends and family. People who know you well might want to loan money to your business. Clarify repayment terms in a professional manner so borrowing doesn't harm your personal relationships.

  • Community development lenders serving micro and small businesses. These lenders may have slightly different loan requirements than traditional lenders, depending on the requested loan amount. But they may serve as the first step in obtaining financing. Venturize from OFN offers a free online resource that includes a directory of mission-driven lenders for small business owners.

  • Credit cards. Business credit cards are flexible, and many have a grace period before charging interest on outstanding balances. They can also help new businesses establish business credit.

  • Bank loans. Borrowing from a bank often requires a qualification process and a structured repayment plan, but it can build your business's credit profile while providing the funding you need.

  • U.S. Small Business Administration (SBA)-backed bank loans. The SBA offers basic 7(a) loans, long-term, fixed-rate 504 loans, and microloan financing options. Obtaining an SBA loan can also help you secure other financing by establishing you as a trustworthy borrower. Learn more about SBA loans.

  • Business lines of credit. Lines of credit let you access preapproved funds quickly and only pay interest on the amount you use. This can help cover short-term funding needs and offer flexible use and repayment.

Equity financing

An alternative to taking on debt is equity financing, in which you sell a portion of your company for cash. There's no need for collateral and no loan payments to impact your cash flow, but investors do get partial ownership. Equity investors are more like partners.

Sources of equity financing include:

  • Personal savings. If you have the money, drawing from your personal savings is a quick and easy option. However, if you invest your personal savings in your business venture, it may take some time to get your money back.1

  • Friends and family. Your personal connections can make an investment in exchange for partial ownership. Again, make sure you handle this exchange professionally to avoid damaging relationships.

  • Employees. Staff members may want to invest in the company's growth with their own money. If you raise funds this way, create an agreement that outlines what will happen if an invested employee leaves or is dismissed.

  • Venture capitalists. Venture capitalists (VCs) provide larger amounts of money than friends or employees. They can also offer valuable business guidance in exchange for their investment. However, VCs may exert more control over your business decisions.2

  • Angel investors. Angel investors often invest in startups earlier than VCs and require less intensive due diligence. They make similarly large investments, but can demand a larger share of the company and higher returns.

Alternative business financing options

Outside of more traditional business loans and equity financing, you can explore other funding sources such as:

  • Grants. Although generally restricted to nonprofit entities, you could qualify for a grant if your business aligns with the grantor's mission and you commit to regular reporting requirements. Learn more about small business grants.

  • Crowdfunding. You may be able to raise funds through a crowdfunding platform, such as Kickstarter or Indiegogo. By creating a profile that introduces your business and explains your goals, many people can make small donations to your campaign. Depending on your initiative, you may give equity away in exchange for these contributions. Consult with your accountant or tax attorney about the tax treatment of crowdfunding.

  • Peer-to-peer lending. Like crowdfunding, peer-to-peer lending allows potential investors to review your funding request online. If they choose to contribute, you pay interest on the money you borrow. Prosper and Funding Circle are two platforms that can help you find lenders.3

Ideally, your business's debt should not exceed three to four times your equity or net worth, according to Mike Strathman, division lending manager at Wells Fargo. Carefully review your financing options, and consider how much debt you can incur.

Use this loan repayment calculator to help guide you through your loan options.

 


1 "How to Finance Your Start-up Business." Small Business BC. (2015) http://smallbusinessbc.ca/starting-a-business/how-finance-your-start-business

"Debt and Equity Financing." About Money. (2015) http://bizfinance.about.com/od/generalinformatio1/a/debtequityfin.htm

2 "How do Angel Investors differ from Venture Capitalists?" Rockies Venture Club. (2014) http://www.rockiesventureclub.org/colorado-capital-conference/how-do-angel-investors-differ-from-venture-capitalists/

3 "Crowdfunding or peer-to-peer lending — which is best for my business?" Funding Circle. (2014) https://www.fundingcircle.com/blog/2014/03/crowdfunding-or-peer-to-peer-lending-which-is-best-for-my-business-2/

SHARE