The most difficult part of starting a company is not the generation of ideas, founders have plenty of those, the struggle is capital and how to hit the ground running.
To raise funds for your business, there are two types of financing options available to you: equity financing and debt financing. It does not have to be one or the other; a lot of companies use a mix of both.
These two financing options are distinct from each other and thus have their own set of pros and cons.
If you have an amazing business idea and need funds to jumpstart your business, or just want information so you can avoid committing common fundraising mistakes in the future, read on.
What is equity financing?
When you decide to take the equity financing route, you are going to take on and be accountable to investors. In exchange for the money they contribute to your company, you give a portion of your company to them. If you decide to sell 5% of the company’s ownership, then the investor who buys it becomes the owner of 5% of your company. Of course, being a part-owner gives that investor the right to be part of some business decisions from moving forward, depending on how you structure the deal.
The beauty of equity financing is that you do not commit to paying back the money you raised through it. With equity financing, you can focus on growing your company by investing available capital since you are not burdened by having to repay investors on a set timeline.
Types of equity financing
- Angel investors
Angels are investors who have a substantial amount of money that they use to provide funds for startups. They are not associated with any financial institution and invest their own money, thus they set their criteria when looking for companies to fund.
Angel investors simply look for founders who have innovative ideas and skills to boot. If your idea catches their fancy and they like you, then your chance of getting funded is high. Angel investors also provide mentorship since they are often highly experienced business executives themselves.
- Venture capital
There are venture capital firms that can help you with your financial requirements. These companies provide funds in exchange for partial ownership of your company. VCs look for a high rate of return on their investments.
While angel investors use their own money, VCs use money pooled by several investors that are managed by a fund manager.
- Initial Public Offering
An IPO is when you decide to go public, by offering stocks to the public for the first time. This can be done through a publicly-traded market like the New York Stock Exchange.
If you want to go public, you need to go to the Securities and Exchange Commission to have your IPO registered and approved. If you are approved, the SEC will give your business a listing date, which is the date when your shares will be available on the market you choose to trade on. The next step will be to attract investors by letting them know about your offering.
- Small Business Investment Companies (SBIC)
Small Business Investment Companies offer venture capital funding to small businesses. VC firms collect investors’ money and pool them so they can invest in startups.
- Equity crowdfunding
With equity crowdfunding, you sell the shares of your business to the crowd. You sell a part of your business’ ownership interest to investors through a crowdfunding platform. This way, your business can remain private, yet raise funds from the public.
- Royalty financing
Investors in royalty financing expect to be paid after you make a sale of your products. They get a percentage of the income received from your sales.
What is debt financing?
In debt financing, you borrow money from investors and you pay them back at a certain time frame with interest. Loans are the most common type of debt financing. There are three main forms of loan programs.
- Installment loans. This type of loan has a set term of repayment. You will get a lump-sum upfront which you will pay back in monthly installments in equal amounts.
- Revolving loans. In revolving loans, you do not get a lump sum. Instead, financial institutions allow you to gain access to a revolving fund of credit. You can use this to get cash, repay it, and then do it all over again.
- Cash flow loans. Here, you get a lump-sum from the lender. You pay back a cash flow loan while you earn the revenue you are using to procure the loan.
The advantage of getting a loan instead of equity financing is that you will never lose control of your company. However, unlike in equity financing wherein you are not obliged to pay your investors, you are expected to pay back your debts regardless of your business’ performance. It is also possible that you will have to pay back your debts using your own money.
Types of debt financing
- Bank loans
These loans are not only offered by banks, but by credit unions and other commercial lenders as well. Bank loans have stricter requirements as compared to other forms of debt financing.
The advantage of getting bank loans is that they typically have the lowest interest rates. If you pass their requirements, then this is often your best bet.
- SBA Loans
SBA loans are popular for their low-interest rates and favorable terms. Sometimes, they require collateral and can have lower requirements than those of bank loans. However, the application process takes more time.
- Business credit cards
Business credit cards are one form of revolving loan where there is no required minimum annual revenue. You are just given a revolving fund of credit, but they do charge high-interest rates. The trick here is that you pay the full amount each month so you do not have to pay interest.
- Business line of credit
This is another type of revolving loan that you can draw capital from each time you need it. There is a predetermined credit limit.
Business lines of credit are advisable for short-term financing needs. However, interest rates are higher than other forms of debt.
- Equipment financing
You can get financing for equipment that you will need for your business operations through equipment financing. The equipment that you bought using the loan will be your collateral, say a vehicle, or a network of computers.
- Merchant cash advance
Merchant cash advances are usually the last resort for businesses that do not qualify for other loans. Still, this may come in handy if you need short-term capital. Interest rates are very high and repayment is expected quickly
When choosing which form of financing to use, consider the consequences for both equity and debt financing. If you are fine with losing a part of your ownership of your company in exchange for capital, then you can go for equity financing. Remember that you are not obliged to pay back your investors if things go south, which makes equity financing attractive to some founders.
However, if you do not want to lose any shares of your business and can qualify and pay the interest, then debt financing may be your solution.
Many companies, especially in the early stages fund their growth with a combination of equity financing and loans.