Debt or Equity? Determine the Right Capital Mix for Your Business

Surplus cash is necessary to run a small business successfully. At times, a company's financial standing is not strong enough to withdraw cash, and the liquidity position is disrupted. Raising money through small business loans or relying on individual investors may be unavoidable in such scenarios. Yet, both options have their own set of challenges. That's why small business owners have to understand the inner workings of debt and equity financing to ensure they choose the right funding path. 

What is debt financing? 

Debt financing is the process of arranging funds for your business through borrowings. These borrowings can be in the form of secured or unsecured loans that will eventually have to be paid back to the lender at a certain interest rate.  

Debt financing comes in various forms.

• SBA loans: These loans are backed by the U.S. Small Business Administration, enabling banks to extend funding to borrowers they may have ignored previously. SBA loans typically have low interest rates and long repayment terms. The three types of SBA loans are the 7(a) loan, SBA Express loan and the 504 loan. 

• Term loan: With a term loan from a bank or alternative lender, you agree to borrow money and pay it back over a set amount of months or years. Many term loans have fixed interest rates, which means you pay the same interest throughout the life of the loan. 

• Line of credit: This is a revolving loan you can draw down on when you need it. 

• Merchant cash advance: With a merchant cash advance, a lender will advance you money on a portion of your future credit card sales. You pay back the loan as a percentage of daily credit card sales. 

• Equipment financing: This is used to purchase a piece of business equipment. Equipment financing is easy to get approved for since the equipment is used as collateral. 

• Invoice financing: With invoice financing, you get an advance on your clients' unpaid invoices. Typically, the lender will advance you as much as 85% of the value of the outstanding invoices. You get the remaining 15%, excluding fees, when customers pay their bills. 

FYI: There are various types of business loans. Each has pros and cons, and each option is best for different purposes. It is crucial to have a clear understanding of what you will use the loan for and how long you think it will take you to pay it back when choosing which loan is right for your business.

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What is equity financing?

Equity financing is the process of raising funds by selling off shares of your business. Under this type of funding, a portion of the ownership in the company is traded in return for funds. Like debt financing, equity financing comes in many forms. 

• Angel investments: These are typically geared toward businesses just starting out. An angel investor puts their own money into a startup or small business. In exchange for the investment, the business gives the angel investor a stake in the company or agrees to pay them a percentage of profit. If the business fails, it won't have to pay the investment bank. 

• Venture capital: Venture capitalists (VCs) don't use their own money to invest in small businesses; they do on behalf of their firm. Often, VCs are looking for high-growth companies that can be the next Facebook or Google. Investments are typically concentrated in tech, but there are VCs out there for any company experiencing fast growth. VCs get equity in the company in exchange for the investment. Some will even take seats on the board. 

• Initial public offering: With this type of equity financing, you sell shares to the public via an initial public offering. This is a route taken by more established companies that have substantial revenue, even if they are not profitable. 

Is debt or equity better?

While the key underlying difference between the two types of funding structure is clear, further distinctions are vital for an entrepreneur to make the right decision.

In the case of debt funding, the downside is the interest payment. That can be costly depending on your credit score and the terms of the loan. With debt, you have to pay back the loan whether or not your business is making money. 

Equity funding has its downsides, too. It dilutes ownership and reduces the controlling stake in the business. The primary obligation under equity financing is the need to generate consistent profits to distribute dividends.

Did you know? Debt financing offers tax advantages, as interest paid on debt can be deducted from a business's income. Dividends paid under equity funding are not tax deductible.

What risks are involved?

Both types of financing carry a certain amount of risk that you must account for before making a financing decision.

Equity funding is generally classified as high-risk financing because raising too much capital through equity investors could reduce your control of the business. The majority owner might try to influence the company and make decisions that are not in sync with your business goals. Similarly, with higher-debt funding, the company's financials will signify a high debt-to-equity ratio. To banks, this is not a sign of a healthy business. As a result, taking out loans becomes problematic in the long run because it suggests the company does not have adequate liquidity and may go bankrupt. 

Apart from this, with continued debt funding, the growth of the business is restricted. The loan has to be repaid within a certain period of time, which eliminates using surplus cash to expand the business. In the case of equity, on the other hand, the funds are not repaid and can be used to expand your business's horizons. However, based on the agreements you sign with investors, dividends must be paid out within the specific timelines. Failure to do this will negatively impact your business.

Bottom line: Whether you are taking out a small business loan or raising equity, risks are involved. You have to figure out if you want to give up control of your business or carry debt.

How should you choose between debt and equity?

To determine the optimal capital structure for your business, you must ascertain the cost of capital involved in raising funds. In the case of debt financing, the cost of capital is the interest rate levied on the loan. For instance, on a $100,000 loan with an interest rate of 6%, the cost of capital is $6,000, which will have to be repaid over and above the principal amount.

When you choose equity as your funding method, the cost of capital is calculated through the capital asset pricing model (CAPM). This is the formula: 

(Risk-free rate) ÷ (Company's beta x Risk premium) = CAPM

This finds the value of the larger investment market and the relative value of the company's stock (represented by beta). Based on these parameters, you can determine the cost of funding debt and equity.

Find a mix between debt and equity that will yield the best funding option at a reduced cost of capital. The mix should minimize the cost of capital and the risk of bankruptcy.

Your business needs funds at its disposal, but a capital structure is evaluated with debt-to-equity ratio. If it is too high, this ratio will have negative implications. Therefore, to deal with business downturns and uncertainties, the ratio should be lower. Conversely, a business with a cash surplus and capital assets, such as land and buildings, can be more highly leveraged. Following these fundamental principles can help businesses overcome financing impediments.

Evan Morris contributed to the writing and research in this article.