Two thirds of Americans want to start their own business.
Some of us will use this passion to launch the next Apple (AAPL - Get Report) . Others will have a great idea that just won't pan out. The market is harsh and fewer than half of all small businesses last longer than four years. It doesn't mean you had a bad idea or shouldn't try again.
Unless you'd like to open a bar. Without experience in the restaurant industry do not buy a bar.
Wise or otherwise, opening a small business takes money. To a certain extent you might fund the new venture out of your own savings, but it's extremely unlikely you'll have enough cash on hand to pay for everything. Sooner or later (especially if your business begins to grow) you will need to look for outside financing.
For an entrepreneur, there are two main forms of financing: debt and equity. Here's how you should decide between them.
The Four Forms of Startup Financing
There are four main ways that entrepreneurs fund their small businesses.
As noted above, this is when you reach into your own savings to fund the business.
Self-funding is overwhelmingly common for the early days of any small business. In fact approximately 77% of small businesses owners start their business out of their own pocket either in whole or in part.
There are many advantages to self-funding, most notably that you don't have to sell anyone else on a dream that doesn't exist yet. The downside, of course, is that you spend your own money, lose that money if the business fails, and will probably not have enough cash on hand to pay for all the (often considerable) costs of running a business.
It is also common for small business owners to take out loans from family and friends to start their businesses. While this is similar to debt financing (discussed below) it differs chiefly in that this is an informal loan.
Note that a loan from family and friends can be formal debt financing. When it is a handshake, zero-interest deal, though, it becomes informal lending.
Debt financing is when you borrow a specific sum of money from a financial institution. This comes with financing terms and a fixed repayment schedule.
This is often more readily available to most small businesses than equity financing, as with debt financing the lender is guaranteed to get its money back except for in extreme circumstances such as insolvency or breach of contract.
Equity financing is when you sell someone a percentage of the business in exchange for operating capital. You receive a fixed sum of money, valued at whatever you and the investor agree is a fair price for that percent of the business. In exchange he or she is entitled to that share of your profits and potentially a say in how the business is run depending on how you structured your deal.
Equity financing tends to be less available for a small business owner, as you have to convince the investor that your business is so viable that they will see a long-term profit off this investment.
Debt financing and equity financing are the two formal structures available to many small businesses. When your business hasn't yet started to generate its own operating revenue and neither your savings account nor your college roommate can make up the gap, you need to find an outside source of capital.
It will usually come in one of these two forms.
How Does Debt Financing Work?
As noted above, debt financing involves borrowing a fixed sum of money in exchange for a repayment schedule and an interest rate.
There are a number of types of debt financing available to small businesses. Some of the most common include:
• Credit Cards - If your business has a credit card in its name, this is a form of debt financing. You are borrowing money and promising to pay it back according to the terms of your credit card contract. Note that if you use your own credit card, it is closer to self-financing given that you will use your own money to repay the bill.
• Bank/Term Loan - A financial institution will give you a fixed loan up front and in exchange you will make payments over time with an interest rate. Small business loans are a common form of bank loan. Sometimes this is referred to as a "Term Loan" as you can get lump-sum loans from a variety of institutions.
• Credit Line - A financial institution can also give what's called a "line of credit." In this case you don't receive the full value of the loan up front. Instead, you borrow what you need as you need it up to the maximum of the credit line, then make payments according to the terms of the loan.
The Advantages of Debt Financing
There are a few main reasons why a small business owner would reach for debt financing.
• Accessibility - Except in rare cases, debt financing will almost always be easier to secure than equity financing. There are a wide variety of debt financing options, and financial institutions which issue debt financing to small businesses are common.
• Fixed Repayment - Your repayment is knowable, known and ultimately ends. You can plan for the repayment terms of your loan and build it into your business plan as a foreseeable expense. Once the loan is paid off it is gone forever.
• Total Control - With few exceptions your lender has no say in how you spend this money. You will not lose control over how you run your company.
• Insolvency - When taken out in the name of the business, rather than as an individual, the liability of debt financing will not last longer than your business. If the worst should happen and you have to close shop the debt will not attach to your personal assets.
The Disadvantages of Debt Financing
Yet there are several reasons why this option might not work for you.
• Fixed Expense - Taking on debt means new costs and cash flow issues. You have to pay off the interest on this loan and have to incorporate the terms of repayment into your costs of business. Failure to repay the loan can, in extreme cases, lead to the end of your business.
• Inflexible - This is a fixed expense. You can't trim your payments during a downturn or take any other steps to react if business goes bad. You will be stuck with this loan.
• Accessibility - While debt financing is generally much easier to secure than equity financing, it still can be hard for a new business. If you're just starting out, odds are your LLC won't have the corporate and credit history that most banks look for when approving a loan.
How Does Equity Financing Work?
Equity financing, as noted above, is when you sell a percentage of your business in exchange for operating capital.
This can involve a sale to private investors, to an institution or even to family and friends. For a small business in the retail, service or food and beverage sectors, it is very likely that your investor will be a friend or family member.
You and your investor will decide what a fair value is for your business, and how much they will pay to own a part of it. There are three main things to know about how equity financing affects your business:
• Profit Sharing - You will share a percentage of your profits in proportion to how much equity you sold. If your investor owns 10% of your business, you will owe them 10% of your profits.
• Joint Control - Depending on how you structured this deal, your investor may be entitled to some control over how you run the business. It's partially their business too now and this may mean sharing the day-to-day.
• Indefinite Relationship - Unless your deal says otherwise, an investor is entitled to keep their share of the business indefinitely. If you sell 10% of your business for startup capital you may have to share 10% of its profits forever.
Note that profit sharing doesn't mean you will immediately start handing over a check every month. A casual form of equity financing might look like this (say, if your brother buys 10% of your bar to help you get it off the ground). Most professional financing will structure the deal based on when the investor anticipates seeing a return, and this makes profit sharing more structured and predictable.
The Advantages of Equity Financing
There are several reasons why business owners seek investors.
• No Credit History - Investors are buying into your dream and your business plan. While an investor will be strict about reviewing your business for viability, they are not often worried about issues like credit history and cash flow. This can make equity financing an option for brand new businesses in a way that debt financing is not.
• No Repayment - You don't have to account for debt payment in your cash flow and you don't have the extra costs of paying for interest on a loan. As far as operational expenses go, equity financing is not a burden.
• Relationship Building -If you get capital from someone who has succeeded in your field, you can create a relationship with someone with insight and experience. This can be invaluable to helping your business flourish.
The Disadvantages of Equity Financing
There are also several reasons not to reach for equity financing.
• Profit Sharing - Your business doesn't lose money, but you do. Equity financing means splitting all of your business' profits with someone else, which can be particularly frustrating in the early years when you are just trying to make a living off of this. It can also divert funds from business growth if your partner demands higher returns than you would like.
• Losing Control - Your investor now has the right to an opinion about how you run the business. Depending on how much of the business you sold, this might give them a lot of control over how you run your business.
• Difficult to Access - While equity financing is often available to younger businesses than debt financing, it is also harder to secure. There are a wide variety of debt financing options on the market, while finding an investor is time-consuming and difficult. Further, most professional investors are looking for high-yield businesses. This means that they invest in only a relatively few types of companies. If you have a tech startup, angel investors might come knocking on your door. If you'd like to simply start your own clothing boutique, don't expect their interest.