How to Find the Right Mix of Debt vs. Equity Financing
Finding the right mix of debt versus equity financing to start your business can make all the difference in its survival. In creating your business plan, you should take a look at all the potential sources and determine the balance that’s right for you. Most entrepreneurs use their own savings (equity) as a starting point. In fact, according to the 2014 Small Business Success Study, 36% of small business owners have used personal sources (i.e. non-retirement savings, retirement savings, or capital from family and friends) to fund their businesses during the past year. But for many, personal sources won’t cover all the bases—which is where debt financing comes in.
No one wants a huge amount of debt hanging over their business. Often, though, a business loan at an affordable interest rate can provide the means to get you started, keep you afloat in a downturn—or supplement the portion of your personal savings that you invest.
- Using your personal savings. In a perfect world, you’d have the personal assets to fund your business and still have money left over for all your other needs. But that’s not the case for most of us. It’s important to remember that it’s unwise to sink all of your personal assets into your new business, especially if you have dependents. Maintaining your -- and your family’s -- quality of life, paying for your home, sending your children to college, and preparing for your retirement are all critical goals as well.
- Money from family and friends. If your extended family or friends are in a position to do so, you might consider asking for start-up capital. This can take the form of an equity investment in exchange for some form of ownership, or a business loan—or both.
We’ll discuss this option in greater detail in the next section. But keep in mind if you’re going to invite others to invest equity in your business, you’ll need to come to an agreement about what kind of partnership stake they’ll be taking on. Will they be active or passive investors?
- Angel investors. Angel investors are typically savvy businesspeople with the capital necessary to buy equity in a company. It goes without saying that they invest in companies that they do due diligence on and only invest in companies they believe have potential. You’re most likely to have access to this option after the start-up phase, when your business’s upside potential is more clear.
Likewise, equity investments from another type of hands-on investor, called a venture capitalist, also aren’t common for companies that are just starting out—unless you’re launching a company with wildly promising growth potential. Consider them as your company grows and begins to demonstrate success.
- Crowdfunding for equity or loans. Crowdfunding involves using social media to find seed financing on the web. Some sites focus on debt, others on equity financing (equity crowdfunding). These collectives are proliferating. This means that you could find a source of financing, with terms and conditions you can work with, aligned with your business plan.
- Loans from for-profit companies. There’s a huge range of companies in the business of making loans, from banks to credit card companies. Be sure to shop around, as interest rates vary. We all know the drill: Don’t overextend yourself—or take on a high interest rate that will compound out of sight. Credit cards are notorious for this.
- Borrowing against existing equity. You may have existing equity that you could tap into to start your business—or use to get it through a rough patch. These sources include loans against insurance policies, retirement funds, and home equity. This kind of funding should carry ‘proceed with caution’ flags, as using them puts your personal assets at risk.
As an example, you could take out a second mortgage on your home. But as the subprime mortgage crisis demonstrated, many businesses went under as a result of having their start-up financing rely on second mortgages—particularly adjustable-rate mortgages. When home values slid, it became very difficult to refinance those loans. Borrowing against a life insurance policy is another example. If your business struggles and you can’t pay off this type of loan in a timely manner, the consequences can be significant, including a lapse in the policy’s coverage, and/or diminished benefits for your policy’s beneficiaries.
- Loans from the Small Business Administration and other agencies. The SBA offers a range of loans to small businesses. Like any business loan, loan eligibility is based on qualifying criteria and your business’s characteristics. Many SBA loans are tailored to very specific purposes, like purchasing real estate and equipment. In addition to the SBA, your home state may also offer small business financing programs.
Paul Quintero on Debt vs. Equity
Should you finance your business with debt or equity? Paul Quintero, CEO of Accion East, explains the advantages and disadvantages of both options.