Financing Growth: Debt vs Equity

When we look to scale businesses we are often confronted with the harsh reality that there is simply not enough cash available to do all of the things we want to do. We have grand plans for expansion into new markets, a flash marketing campaign, or a new product launch but the bank account simply says no. Knowing that the next big step for your business will require a sizable cash infusion can be daunting.

It may represent a years worth of saving profits to begin a new expansion but you know that if you wait that long you will miss the boat. That leaves really just one option, fundraising.

But how do we know which route to take to fundraise? With the plethora of options out there it can be quite intimidating trying to decide which route is best. Should you sell equity? Take out a loan? Try for a kickstarter campaign? It is hard to say which option is the best but there are some general guidelines that can help make this choice just a little bit easier.

Loans

Taking a loan from the bank is often a small business owner's first instinct. You likely already have an established relationship with a credit union or bank (if not build that relationship NOW) so you can likely get a pretty good set of terms for your loan. Especially in today's historically low interest rate environment taking a loan is a very attractive option. However, there are some key issues with taking out a loan that should be considered. The first major consideration is that by taking out a loan you are assuming a liability on your balance sheet. This is not necessarily a bad thing but you must be mindful of what level of liability your business is assuming as this may impact your ability to pivot down the road if things get tough. The general rule of thumb is to make sure you have no more than a third of your gross revenue in debt at any given time as a small business.

Another key concern with debt is the issue around mandatory payments. While you may be able to handle the debt and interest payments in good times this will severely limit your ability to weather a financial calamity.

We often forget that, at the end of the day, the law requires that debt holders get paid first when things start heading south for your business. Missing even a single debt payment can allow your creditors to call your entire loan and force your fledgeling firm into bankruptcy. Loans can be a great option for small businesses but they must be used prudently and with a clear plan for how the money being taken out will allow for reinvestment and growth of the overall business.

Equity

Small businesses often don't like to use equity due to the fact that it can dilute your ownership stake. We all like to feel like we are in charge of our business and, let's be honest, we went into business for ourselves so we would not have to answer to someone else. While it can definitely dilute your ownership stake, using equity to raise funds should not be viewed as a negative for small businesses. Selling equity to friends, family, and individuals you trust can bring in much needed investment as well as help bring a diversity of ideas into your business that come from individuals who are invested in how the business performs long term. One particular option I am a big fan of is offering your employees equity in the company in exchange for a lower salary. This has the benefit of saving cash for the business owner as well as helping employees build wealth through the success of your firm.

Another major advantage of equity is the fact that it doesn’t count as a liability on the balance sheet. This will help your business appear more favorable in the eyes of banks and potential acquirers. In addition to these benefits we have the added gains of not needing to make interest payments on the funds you raise and there is reduced risk of being forced into bankruptcy when using equity to finance growth.

The equity holders are incentivised to help the firm grow as they share in the profits of the company and can therefore suspend dividend payments in times of crisis where banks are seldom in a position to suspend interest payments on a loan. Selling equity in your small business to trusted partners is an excellent alternative to the loans we traditionally use to grow businesses.

Overall, there really is no “right way” to finance your company. This will boil down to a matter of what do you think works best for your business and what do you value. If total control of your business is important then maybe equity sales is not the right option. Alternatively, if you are taking on a high risk project maybe it would be better to sell equity to a fellow visionary as opposed to paying interest to a bank for a project that may not work out in the end. Finding the right financing mix is tough, but fully understanding the pros and cons of each option can make a huge difference in how your business grows moving forward.