You’ve heard it since you were a kid: being in debt is dangerous. From politicians to radio pundits, we’re bombarded with dire warnings about the dangers of too much debt. Because of this, businesses often choose to avoid taking out loans, instead choosing to sell equity in their business when they’re in need of more capital. Or, waiting to seek debt financing until it’s too late and finding the process difficult because they didn’t establish credit earlier in the business’ evolution.
The truth is that, it’s better to establish business credit early by taking out loans in small amounts and paying them off. Doing this early and often along with increasing the amount you borrow in small increments over time will make it easier to get larger amounts of money. If that isn’t enough reason, in most cases, debt works out to be less expensive than raising funds by selling part of your business. Not only is it less expensive, but the debt can be leveraged to aid business growth and future stability. In a very real way, debt is an investment in your business.
Let’s Do the Math
Over the short term giving up a piece of your business may appear to be less expensive than debt. However, if you plan on keeping your business operating for more than a year, you should carefully consider the long term financial repercussions of selling off a percentage of it – it’s not a decision you can reverse easily, if at all.
Suppose you get a massive order and are in need of an initial stockpile of supplies and the equipment required to build your products. You‘re going to bill at $50,000. In order to fulfill the order, you need $20,000 in inventory and supplies. You could sell off a piece of the company you’re working so hard to build, or you could take out a loan – incurring interest costs but maintaining your equity
Now, let’s say the loan has an APR of 20% – which means that over a year, the opportunity cost for that loan is $4,000.
That means at the end of the day, you’re making a $26,000 profit – some of which can go towards paying off that very same loan. More than likely, that loan has also enabled you to invest in tools that will be used for future projects, which means the next loan will likely be a smaller one, if a second loan is needed at all. Debt can be very profitable if the ROI on the investment is greater than the cost – and you still own 100% of your business.
On the other hand, you could raise cash by selling some equity in the company. Because you’re a startup, let’s say you have to sell up to 25% of your business for the $20,000 that you need. Think about what that means. Even though you didn’t take on debt, you’ll be missing out on 25% of your profit – forever!
Here’s another important factor to remember when you’re figuring out which option is most cost effective: the $4,000 interest on your loan is tax deductible! Depending on the size and its interest rate, your loan could make a considerable difference in tax burden that year. Selling equity provides no such tax savings.
Equity Financing Can Slow Down Operations (Well Past the Sale)
If you do decide to go with equity financing, it’s important to also factor in the amount of time that will be spent on your investors – before and after the equity is sold.
Initially, you’ll need to attract those who are interested in investing in your company. This means not only finding people who want to give you money, but also who you’re willing to make partial owners. Make this decision carefully, as you’ll need to include them in most – or all – future decisions, for as long as they hold their stake.
By choosing equity finance, you’ll essentially be choosing to have co-owners of the business. Even if you hold a majority share, you’ll still need to involve them in decisions, allow them insight into the growth and operations of the business, and convince them of changes as they’re made, plus sharing your profits with them along the way
Debt Builds Up a Useful Resource: Business Credit
As mentioned at the start of this article, taking on business debt, paying regularly and on time is critical for improving your business credit score. This technique is so effective, it’s become common for businesses that foresee the potential for large loans in the future to take out smaller loans that they don’t need, simply to improve their credit profile.
Even if you do not foresee needing to take out a loan in the future, it’s wise to improve your credit score in case your business experiences unexpected turbulence or emergency expenses. Whether because of disaster or rapid growth, it’s quite common to realize that you’ll need a large influx of capital for your business to survive and thrive. Unless your business has a healthy credit profile, your only option may be equity financing – and that may mean selling a considerable, if not majority, share of your company.
Debt should be viewed as an important and vital business tool. As with any tool, you’ll need to use it properly – always pay on time, and don’t take on debt that you’re unable to manage. However, if done correctly, a loan can do a lot more than allow you to invest in your company; debt can serve as a building block for business stability and growth for years to come.
If you have any questions regarding business loans, don’t hesitate to reach out to our Funding Specialists at Currency. We’re always available for a call at 877-358-4595, and would love to answer your questions and guide you toward the best option for your business.