Is it better that your small business has a loan or has shareholders?
Starting a small business can be expensive. There may be a requirement for office space, stock will usually be required and there are ‘hidden’ costs such as fuel for the car to go out marketing the business. Many business owners will use savings to cover some of the early costs but most businesses will need quite a large lump of cash to keep them going for the first 6-12 months while they become established. The two main ways of getting this cash is through debt or equity. Let’s look at the good and bad points of each.
Another term for debt is loan capital and, as with all loans, it is repayable. The usual providers of loan capital are banks. Banks do not lend you money due to some altruistic desire to make the world a better place; they lend you money so that they can make more money for themselves. Banks are usually very risk averse, so the more unusual your business or the newer you are to the business world, then the higher the rate of interest you’re likely to be paying. Banks also like to make sure that whatever happens to the business they will get their money back so you will usually be required to put up some sort of personal guarantee (such as your house).
Equity is money given to the business owner in return for a percentage of the business (shares) or some other similar arrangement such as a percentage of the annual profits (dividend). The person giving that money will then receive their reward when their share of the business is sold or when the whole of the business is sold in years to come. People providing equity are usually willing to take a higher risk than banks because they can see a higher reward. The downside from the owner’s perspective is that the shareholders may wish to influence how the business is being run and what direction it is going in; the bigger the share they own then the more influence they have. If you’re going to run a small business successfully you probably want full control for yourself so this can be a big decision factor.
So what are the other key differences?
The key difference is that debt is repayable and equity isn’t. If you take a loan from the bank they will require regular repayment of the loan and interest and this can have an impact on your cashflow, particularly in the early days.
Another difference is once you’ve paid pack your loan you then owe no-one and still own all the business. So, if you are fantastically successful then you own all that success. If you took equity to get you going then you will continue to pay out to those shareholders unless you can afford and arrange to buy back the shares.
The best way to start a small business is to not need any assistance from external financiers at all but that’s not possible for the majority of people. There are pros and cons on both sides of the debt/equity argument and these will change from business type to business type. What you need to do is review your own personal requirements and then take advice from an independent source to determine which will be best for you.