Raising Money for Your Small Business: Loans vs. Equity InvestmentsHere is the lowdown on whether to borrow money or sell part of your business to an equity investor.
To raise money for your new business, you must decide whether you want to borrow money or sell ownership interests to equity investors. Often, you may not have many options -- the person with money to lend or invest will obviously have a lot to say about it. But you should understand the pros and cons of choosing one over the other.Taking Out Business Loans
Borrowing money to fund your business has many advantages. Often, you'll borrow this money from a friend or family member, but if you're lucky, you may be able to borrow from a commercial lender too.Advantages of Borrowing Money
The main advantage of borrowing money is that, while the lender will charge you interest for using the money, the lender won't have any say in how you run or manage your business. More importantly, a lender won't be entitled to any of the profits you make; all you have to do is to repay the loan on time. In addition, you can typically deduct the interest payments (but not principal repayments) as a business expense.
If you can borrow money from a friend or family member, you'll typically pay a lower rate of interest than if you borrow the money from a commercial lender, and you can avoid paying the loan fees commercial lenders tend to charge. As an added bonus, you may be able to negotiate more flexible repayment terms than a commercial lender would permit.Disadvantages of Borrowing Money
If you borrow money, you may be committing your business to a fairly large business expense. You may have to make loan payments when your need for cash is greatest (usually during your business's start-up or expansion). And if you have problems paying the loan back or keeping up with the payments, you can ruin your relationship with family or friends.
If you borrow from a commercial lender, the lender may require you to pledge property as security for the loan. (If you don't repay the loan, the lender can take the property and sell it to recoup the money.) If you pledge business property as security for the loan, and your business slows down (or doesn't take off) and you can't make loan payments, you may lose these valuable assets just when you need them most. Worse, if you pledge personal assets, such as your house or stock portfolio, you risk losing them to pay a business debt.
Even if you organize your business as a corporation or a limited liability company (each of which provides owners with limited liability for business debts), almost all commercial lenders will require you, as the owner of a new or small business, to personally guarantee the loan and/or to pledge personal assets to cover the loan, which wipes out this limited liability.Accepting Investments
If you have friends, family, or other people who want to invest in your business outright (become part-owners) instead of simply lending you money, you can raise money for your small business this way too. However, allowing people (called equity investors) to own part of your business comes with its own set of advantages and disadvantages.Advantages of Equity Investors
First, there's a good practical reason to take investments: Raising money through equity investors allows you to use your cash to pay business start-up expenses rather than large loan payments. And unlike a loan, if your business loses money or goes broke, you probably won't have to repay your investors their initial investment. As long as you've thoroughly disclosed the risks involved in your business, your investors should understand and accept that they are not guaranteed to get their money back.
Further, investors often have business experience and can offer you valuable advice, moral support, and assistance.Disadvantages of Equity Investors
On the downside, equity investors usually end up taking a larger share of your business's profits than a bank or other lender. (Since an investor is at a greater risk of losing his or her investment, you have to compensate the investor for this risk with a bigger payoff.)
In addition, your investors will be co-owners, and they have a legal right to be informed about all significant business events, as well as a right to ethical management. Your co-owners can (and probably will) sue you if they feel you are compromising their rights. This means you always have a responsibility to take your investors' interests into account when you make business decisions, even if it's not what's best for you.
In some circumstances, your investors may be considered passive investors and their investment interests "securities." Dealing with securities creates a lot of paperwork, starting with securities registration, and brings a host of other legal requirements down on your head. However, not all offerings of securities must be registered with the federal and state securities exchange commissions. The following are exempted:
- private offerings to a limited number of persons or institutions
- offerings of limited size, and
- intrastate offerings.
For a quick summary of these exemptions, see the SEC website at www.sec.gov.
If you're trying to finance a start-up venture, it's better to seek equity investments, because you generally only have to repay investors if the business turns a profit.
For ongoing needs, loans are better for businesses with cash flow that allows for realistic repayment schedules, and for businesses that can obtain the loan without jeopardizing personal assets.
Deciding whether to borrow money or to take on co-owners can be tricky. If you don't already know a tax advisor who specializes in small business issues, it would be wise to find one. Your personal tax situation, the tax situation of the people who may invest, the terms of a potential loan, and the tax status of the type of business you plan to open are all likely to influence your choice.