Business Debt vs Business Equity: Which is Best?
By Tom Gazaway
If your business needs money, there are really only two ways to get it. They get dressed up with a lot of names, but when you boil it all down, there are only two basic routes to the cash: debt or equity.
Debt: You borrow money and pay it back. The transaction is fairly straightforward. You get a small business loan or a business line of credit, paying interest for the privilege of borrowing the money. Your business repays the money on a schedule determined by the lender. Or you borrow the money on a credit card and pay it back. Or you borrow the money from Uncle Louie and pay it back.
You get the picture. In any case, the debt does not reduce the ownership stake you have in your business.
Another key point on debt: No matter how well your business does, the amount of your debt will not change – except for the obvious fact that as you make the scheduled payments it’s likely that you’ll pay down on the principal over time.
On the dark side, if your business goes bust, you will still owe the debt unless you declare bankruptcy. Either way, the unpaid debt may well impact your personal credit rating.
Equity: You give an investor an ownership stake in your business in return for use of their money. In three to five years, you need to pay off the investor with a substantial profit. Often, there are few options for how to generate this payoff. For most businesses, it’ll require either selling the business or taking the company public in an initial public offering. That last one is an option available to few businesses really, and they’re concentrated in a few industries such as technology and healthcare.
What many business owners don’t realize is that equity is almost always more expensive than debt. Why? Because the investor is providing what’s known as “patient capital.” The investor puts in their money and you don’t have to repay a dime of that cash for several years. In return for that patience, the investor expects a big payoff — far beyond what you expend simply paying interest on a loan.
The only time debt is more expensive than equity is when the business fails. Then, in an equity scenario, the business owner usually doesn’t have to pay the investor back. The investor has basically gambled on the company’s success, and lost. But nobody wants to get out of a debt that way!
If your company has become a huge success, on the other hand, then the investor expects to share in that bounty. The investor actually owns a piece of the business. So if you sell your company or do an IPO, the investor will get an owner’s cut of that payday. The potential payoff could be huge — and that’s all money you would have kept in your pocket if you’d gotten your growth capital through debt instead of equity.
For most business owners, this isn’t a tough decision: Debt is almost always the better way to go if enough of the necessary capital can be acquired through debt. It’s also common for a combination of debt and equity to be a good solution for some business owners.
Have questions about how to use debt to grow your business? Contact the business financing experts at Hawkeye Management. We’re happy to help.
Photo via Flickr user Jay Tamboli
