Most entrepreneurs start their business ideas with their own money (aka, bootstrapping). However, relying on your own capital can limit your business’ growth potential and this is why some entrepreneurs and business owners turn to financing.
What is financing?
Office space can be costly and leasing a coworking space can be a more cost-effective way to achieve the same goal. However, with full-time coworking memberships in Sydney (Australia) averaging $800 per month – you may not have enough cash reserves to do so.
In this context, financing refers to the way of getting additional supply of money (or capital) for a business and some of this cash injection can be used towards a coworking space. Traditionally, this is done through a loan agreement and there are two types of business financing: debt financing and equity financing.
What is debt financing?
As the name implies, a debt is a loan that must be paid back with interest. That is, you as a business will borrow money from a lender to facilitate growth. Therefore, debt financing is when you source funds from a third-party, such as a bank, and agree to repay the money back plus interest, by a future date.
A business loan is one of the most common forms of debt financing and these can be secured or unsecured. A line of credit is another form of debt financing that entrepreneurs can explore. Follow this link to learn more about types of business loans, borrowing power, and how commercial lenders evaluate loan applications.
As with many financial products, debt financing has pros and cons:
- One of the major advantages of taking out a business loan from a commercial lender is your interest payments, fees and other charges on the loan are tax deductible.
- Monthly repayments is a relatively fixed expenditure item and can be easily included into forecasting models so that you can estimate when your business will break even or become profitable.
- You maintain ownership of your business venture (this is a primary difference between debt and equity financing) and you retain authority on how to run your business.
- Similarly, your loan repayment does not impact your profit margin (again, a primary differentiation between debt financing and equity financing).
- Once the loan has been repaid, your debt is gone.
- Most commercial banks will apply scrutiny to your financials and business plan. That is, securing a business loan can be difficult for certain services and business ideas.
- If you are set up as a sole proprietor (sole trader) and your business does not succeed, you may be personally responsible for any outstanding debts.
- When business slows down, making monthly payments can be very difficult and failing to do so may impact your personal credit score when you default on your loan repayments.
What is equity financing?
Many entrepreneurs begin with equity capital from a source called family and friends.
Equity financing is when a company sells shares of its company to investors. These investors are buying part ownership of the company and getting a say in how it is run. Using the previous example, in order to pay for a coworking space in Sydney, you may consider attracting investors to buy shares of your company. In return, they will float your business with money and you can use these funds for business purposes (e.g., leasing a coworking space, hiring a front-end developer etc).
- There is no money to pay back, and hence, no monthly payments that detract from your business’ cash flow.
- Because there is no money to repay, there is no liability. That is, if the business fails you do not have to find funds to repay what your investors have put into the business venture.
- Improves financial health of your business by having a lower debt-to-equity ratio.
- If your business is successful, investors are often willing to provide additional funds.
- Reduced ownership and decision-making authority.
- Finding investors willing to invest can often be more difficult than securing a business loan.
What are the main differences between debt financing and equity financing?
When you raise capital with equity financing, you sell shares of your company to get money. This is different from borrowing money, because with equity financing you give up some ownership of your company in exchange for the capital you need.
Which type of business financing is right for you?
There are pros and cons of both debt and equity fundraising. Depending on your personal circumstances, a business loan, equipment lease or line of credit may be better suited for you. On the other hand, if you don’t mind giving away future profits and ownership of your business idea, equity financing may be the best option.