Small Business Financing: Debt versus Equity

cartoon on growth chart debt versus equity financing p2binvestor

At some point in your business’s lifecycle, you’ll need an influx of cash to launch a new product, implement a new marketing strategy, hire staff, purchase raw materials, or execute on other growth initiatives. Few businesses are able to scale using capital garnered from sales alone. But finding that money can be a challenge and understanding the real cost of capital isn’t easy. Entrepreneurs have two options when it comes to securing working capital: debt or equity. Which one you choose depends on the stage of your business. Here is what you should know about debt versus equity financing.

Financing with equity

Many companies will do multiple equity raises as they grow. If you need to build a new facility, conduct extensive R&D for new product lines, or attain start-up capital, investor capital might be the answer. Taking equity is a good way to start testing the waters if you’re a young business and still looking to find some traction in your market

Equity is “cheaper” in that you’re not paying interest and often only paying these investors in the event of a sale or public offering. If your company fails, you don’t have to pay your investors back at all. However, if your business succeeds (and most of us don’t launch a business unless we think it will), the cost of raising equity can be exponentially higher than using debt financing options. If you primarily fund your business’s growth by taking on investment capital, you will relinquish control of the business and give up a huge portion of profits down the road—profits that you may have been able to keep had you employed debt financing over equity, or at least a healthier mix of the two.

Financing with debt

Debt financing comes in many forms. The cheapest debt financing can be found at your local bank in the form of a line of credit or a term loan which usually comes with a sticker price of between 5% and 8% APR. However, unless you’ve been in business at least five years, are considered profitable, and have a track record of steadily increasing profits, you’re unlikely to be approved for a bank loan. In fact, banks have seriously tightened their belts on small business loans in recent years, making it tough for entrepreneurs to work with them as a source for growth capital.

As a result, many alternative lenders have entered the market to fill the cash gap. Online lenders provide a line of credit or a term loan like a bank might, but are prepared to meet the needs of earlier stage businesses. You can find loans for anywhere from $1,000 to $250,000 from folks like Kabbage and Bond Street if you’re a lifestyle entrepreneur trying to build a small business you can run for the next 15+ years. If you have an eye on strategic, rapid growth and a large exit, P2Binvestor offers loans of up to $10 million. While the cost will always be higher than what you would find at a bank, it is much cheaper that taking on investor capital. Without financing to fuel rapid growth, you can’t expect a high valuation when you’re ready to sell. Let’s walk through an example of debt-based financing at these rates versus equity financing.

Side by side: Debt versus equity financing

Let’s say Company X has a valuation of $2.5M and wants to exit in five years. They have forecasted growth of 2x year over year. The ownership is split equally between two partners and has no outside investors.

The partners need an influx of $1.5M in working capital to maintain their year over year growth. They received a revolving line of credit at 18% APR that allows them to draw when they need cash and only pay for what they use. If they have an average line utilization of 60%/ over four years their total cost of capital will be $648,000. If the partners retain their equity and maintain their year over year growth, each partner receives $18.75 million at the time of sale.

Now let’s look at the cost of equity.

Company Y also has a $2.5M valuation, an equal partnership, and 2x year over year growth. Both partners decide to raise $1.25M at their current valuation and, therefore, must give up 25% of their shares. Though each partner has reasonable control over their company, they must welcome and consider the wishes of their new co-owners—after all, they own half of the company as well.

Since these lucky investors got in at the right time, they receive $20M of the $40M sale for a profit of $18.75M! The partners still get almost $10M each, but they opted to give up $20M later for $1.25M now and lost almost $8 million apiece.  

The takeaway

A company’s valuation at the time of sale is largely predicated on how quickly it scaled. The type of capital you raise, however, will determine just how big your payout will be at the time of sale. If you need the influx of cash in order fuel your growth trajectory, equity is not always the answer. Depending on where you are in your growth cycle, debt financing might be a better option. Your best bet is to chat with a lending specialist who can take a holistic look at your company, help you understand your options, and talk you through your path to profitability.

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