How to choose between equity or debt financing

When small business owners are considering their options, for financing, it usually comes down to one of two options. Those options are debt or equity financing. It is important to understand that there are significant differences between the two, along with equally significant ramifications. Savvy business owners will do well to fully educate themselves, about both choices, before making a final decision. Here is what you need to know about how to choose between equity or debt financing-

Remember that all money is not the same. This is especially true when it comes to equity, and debt financing. When you are looking for money, you must consider your company's debt-to-equity ratio (the relation between dollars you've borrowed and dollars you've invested in your business). This is because the more money owners have invested in their business; the easier it is to attract financing. No matter what method you end up choosing the first step is to become educated about both ways of financing.

• Debt Financing-There are many sources for debt financing: banks, savings and loans, commercial finance companies, and the U.S. Small Business Administration (SBA) are the most common. In addition, state and local governments have developed many programs in recent years, to encourage the growth of small businesses in recognition of their positive effects on the economy. You may also want to consider family members, friends, and former associates as all potential sources of financing, especially when capital requirements are smaller. However, traditionally, banks have been the major source of small business funding. Their principal role has been as a short-term lender offering demand loans, seasonal lines of credit, and single-purpose loans for machinery and equipment. Banks typically have been reluctant to offer long-term loans to small firms. It is important to realize that lenders commonly require the borrower's personal guarantees in case of default. This ensures that the borrower will have a sufficient personal interest at stake to give paramount attention to the business. For most borrowers this can be a burden, but also a necessity


• Equity Financing-Most small or growth-stage businesses use some form of limited equity financing. Additional equity financing, often comes from non-professional investors such as friends, relatives, employees, customers, or industry colleagues. However, the most common source of professional equity funding comes from venture capitalists. These are institutional risk takers, who can be groups of wealthy individuals, government-assisted sources, or major financial institutions. Keep in mind that most of these investors specialize in one, or a few closely related industries. Venture capitalists are most often portrayed as deep-pocketed financial gurus, who are looking for start-ups, in which to invest their money. However, you may be surprised to learn that they most often prefer three-to-five-year old companies, with the potential to become major regional or national concerns, and return higher-than-average profits to their shareholders. Venture capitalists may scrutinize thousands of potential investments annually, but only invest in a handful. Quality management, a competitive or innovative advantage, and industry growth are also major factors that they will consider before investing in your business. It is important to understand that different venture capitalists have different approaches to management of the business in which they invest. Most (but not all), generally prefer to influence a business passively, but will react when a business does not perform as expected, and then may insist on changes in management or strategy. Giving up some of the decision-making, and some of the potential for profits, are the main disadvantages of equity financing.

Finally, many financial experts recommend that if your business has a high ratio of equity to debt, you should probably seek debt financing. However, if your company has a high proportion of debt to equity, experts advise that you should increase your ownership capital (equity investment), for additional funds. Using this method, you won't be over-leveraged to the point of jeopardizing your company's survival.