Small Businesses: Debt or Equity?
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As a small business owner, raising capital is a critical decision that can impact your business’s financial health and long-term growth. There are two common methods of raising capital: debt financing, which involves borrowing money, and equity financing, which involves selling shares in your company. Let’s take a closer look at these options to understand the benefits and shortcoming of each approach for small businesses.
| Debt | Equity | |
|---|---|---|
| Ownership & Control | Retain ownership | Sell some portion of ownership |
| Repayment Obligations | Obligation to pay back interest and principal | No obligation to pay dividends |
| Costs | Exposed to interest costs but low upfront cost of securing debt | High upfront cost to finding investors and negotiating terms but no cost to the business once investors have invested |
| Collateral | Some business / personal assets may have to be pledged | N/A |
| Partnerships and Connections | N/A | Equity investors can give businesses access to their connections and contacts |
Debt Financing
According to the Small Business Credit Survey conducted by the Federal Reserve Banks, 34% of small businesses sought debt financing in 2021. We highlight some of the benefits and drawbacks of raising capital through debt financing:
1. Benefit - Retain Ownership and Control
By using debt financing, small business owners do not need to sell any shares in their company. Thus, owners continue to have the same ownership as before the capital raise. This can be a significant benefit because holding a larger share of the ownership means that owners will have a right to a larger share of the profits going forward.
2. Drawback - Repayment Obligations
Debt financing requires regular repayment of principal and interest, which can impact profitability and cash flow. Comparatively, there is no obligation to pay dividends to equity holders. This drawback is especially noticeable during times of unforeseen crisis such as the covid-19 pandemic. The Small Business Credit Survey found that 60% of small businesses faced challenges with meeting their debt payments in 2020 due to the economic impact of the COVID-19 pandemic.
3. Interest Rates and Costs
Cost of debt financing can be high for small businesses. This is even more true when the debt has a variable interest rate and interest rates increase such as what happened in 2022. According to the Kansas Federal Reserve, median variable interest rate on small business loans increased from 4.25% to 6.25% from September 2021 – September 2022. Comparatively, there is no obligation to pay dividends to equity holders and therefore, businesses financed with equity are not under pressure during times of higher interest rates to take money out of the company.
4. Impact on Credit Profile
Taking on debt can impact a small business’s credit profile if the business is unable to repay its debts. 37% of small businesses reported a decrease in their credit score as a result of the Covid-19 pandemic effecting their repayment plans. Lower credit scores can reduce future borrowing opportunities and / or result in higher interest rates.
5. Collateral and Personal Guarantees
- Collateral is not necessarily a problem if you are using the debt to invest in a new facility or equipment and use that asset as collateral. However, pledging either personal assets or assets that are vital to your business as collateral could lead to issues if you are unable to repay the debt.
- The Small Business Credit Survey found that 45% of small businesses used their personal credit score to secure financing. Not only does this place your business under increased stress but if you are unable to repay the debts, your personal assets could be at risk of repossession and your personal credit score will be impacted.
Equity Financing
1. Ownership and Control
Equity financing involves selling shares in your business. This means that you are selling some ownership in the business in exchange for capital. Selling ownership today means that you will have a lower share of profits going forward. Depending on the shareholders agreement that you negotiate with the shareholders, you will retain control of your business if you hold more than 50% of the shares in the company. 86% of small business owners in the Small Business Credit Survey expressed a preference for retaining full control of their businesses.
2. Benefit - No Repayment Obligations
Unlike debt financing, equity financing does not require regular repayment of principal or interest. This can provide more flexibility in managing cash flow, as there are no fixed payments to be made.
3. Benefit - Strategic Partnerships
Unlike debt financing, equity financing can bring strategic benefits, as investors often provide expertise, industry connections, and guidance. According to a report by BDO, 75% of small business owners believe that equity financing can provide access to valuable strategic resources.
4. Drawback - Valuation and Negotiations
Equity financing involves valuing the business and negotiating terms with investors. This can be complex, time-consuming and costly.
Conclusion
There is no single prescription for whether a small business should take equity or debt financing. Overall, equity financing gives the management more flexibility and room for error as well as potentially valuable business connections through investors, but equity investment can take time to negotiate (distracting managers from day-today operations) and mean that founders will earn a smaller share of profits going forward. Alternatively, debt financing can be accessed quickly and without much upfront cost, however, businesses have less room to underperform, are negatively exposed to unforeseen crises and incur greater costs by paying interest expenses.