As a small business owner, you could face a dilemma when your company requires a fund infusion. Should you rely on an external source of financing or is it better to use your hard-earned savings? Let’s conduct a deep dive into the debt vs. equity question to arrive at an answer.
Before we begin, it’s a good idea to understand what the two terms mean:
- Equity: This is the money contributed by the owner(s) of the company. Interest is not payable on equity. However, those who hold equity in the business are entitled to a share of its profits. For most small businesses, equity comes from the entrepreneur’s own resources.
- Debt: Many entrepreneurs borrow money from a bank or financial institution to finance their working capital requirements, acquire new plant and equipment, or pay for operational expenses. If you take on a debt, you will be required to pay it back along with interest.
Using equity to invest in your business
Many entrepreneurs launch their businesses with their own funds. The debt vs. equity question is not really an issue for them because they use the money that they have accumulated over the years. Even if they rely on an outside source, their own contribution is usually substantial.
In fact, a shortage of money could deter would-be entrepreneurs from starting their own companies. However, it is possible to overcome this hurdle by familiarizing yourself with the concept of bootstrapping.
What exactly is bootstrapping, and how can it help you in your endeavor to start or grow your business?
Bootstrapping involves launching and running a business with very little capital. The business owner uses his or her personal finances until the company starts generating revenues and profits. If you use this method, it could mean not paying yourself a salary in the initial stages.
So, is it a good idea to finance your business with equity? Here are the pros and cons of this method of financing.
Pros and cons of self-financing your business
- You don’t need to pay interest or worry about repaying the sum that you have borrowed – this could provide you with a critical advantage. The income that your company generates accrues entirely to you. You can grow your business by plowing your profits back into it.
- You can focus on running your business – getting your loan application approved is not an easy task. You will have to comply with certain requirements, prepare various documents, submit them to the bank, and then wait for them to get back to you with their questions. Depending on the institution, the entire process may take weeks or even months, and you could be required to make repeated visits to the bank. If you self-finance your business, you needn’t waste your time on these activities. Instead, you could concentrate on running your business.
- There is no need to put up collateral – if you are going to borrow from a financial institution, it is likely that you will be asked to put up some collateral. What is collateral? This usually takes the form of assets like your plant and equipment or even the property that you own. If you can’t repay the lender, the collateral that you have provided could be seized and sold to pay off the loan. If you use your funds to finance your business, you don’t take the risk of losing your assets.
- You can retain your independence – when you take a loan from a bank or some other financial institution their primary interest is in getting back the sum that they have advanced along with the interest that is due to them. You will be allowed to run your business in the manner that you want as long as your repayments are made on time. But if you delay payments, you can be sure that the lender will soon start breathing down your neck. You may be required to pay a late fee in addition to an increased rate of interest. The lender may even ask for the entire sum to be repaid immediately! However, if you self-finance your business, you won’t face any of these problems.
- Not having enough funds is the biggest drawback of self-financing – this is the reason why most small business owners turn to external sources of finance. You need a significant amount of cash if you want to expand your business, enter a new market, or stock up on inventory.
- You don’t get the opportunity of building your personal or business credit – if you never borrow, how will you build your credit score? Having a solid credit score involves many advantages, while the opposite can refrain your business from expanding in the long run. Most businesses need to approach a lender at some point, and if you don’t have a credit history, you could find it difficult to get your loan approved.
- You lose a valuable tax benefit – did you know that the interest that you pay on a loan taken for your business is tax deductible? If you restrict yourself to self-financing, you will lose this benefit.
- Putting all your eggs in one basket can be risky- this is one of the greatest disadvantages of self-financing. Many entrepreneurs have their entire wealth locked up in their companies. They plow all their profits back into their businesses. If there is an economic downturn or if their business suffers losses for some other reason, they stand to lose everything they own.
How much of my savings should I invest in my business?
Now that you are familiar with the pros and cons of self-financing your business, you may be confused about the next step. If you use your own savings, how much should you use to finance your business?
Here’s a solution. It’s called the 50/30/20 rule. This is a budgeting technique that you can use to your advantage.
It consists of three simple steps:
Step 1: Allocate 50% of your income to your needs. Your rent, mortgage payment, groceries, utilities, etc. would fall into this category.
Step 2: Allocate another 30% of your income to discretionary expenditure. This category is also referred to as your “wants.” Eating out, entertainment, and vacations should form a maximum of 30% of your monthly budget.
Step 3: Now you are left with 20% of your income. You can choose to save this or invest it in your business.
If you follow the principles laid down in the 50/30/20 rule, you’ll know exactly how much to invest in your business. However, it’s apparent that for most small business owners, the amount that can be invested in their companies could be somewhat limited, as they would require most of their money to meet their day-to-day needs.
Tips to self-finance your business
When you are just starting, it’s quite normal to use your own funds to get your business off the ground. Remember that most lenders are usually reluctant to advance money to companies that have been in existence for less than two years. The issue of debt vs. equity may not arise at all as a small business owner who has recently launched a business would find it difficult to raise a loan.
So, the only practical option would be to use your own funds. If you are going to do that, here are some points that you should keep in mind:
- Don’t use all your savings in your business. You should keep some money in an emergency fund. You never know when you may need cash for a medical emergency or an unexpected big-ticket purchase.
- Be careful about how you spend the money that you have allocated for your business. It’s advisable to keep a close watch on your expenses. Do you really need an expensive top-of-the-line computer for your day-to-day work? Or will one that costs half the amount do equally well?
- Open a high-yield savings account and deposit money into it on a regular basis. This will help you to create a pool of funds that you can use in an emergency.
Borrowing money to invest in your business
Remember that if you borrow money for your company’s operations, you are responsible for paying it back along with interest. It’s crucial that you understand this responsibility before you take a loan.
Which are the different types of loans that are available to small business owners? Here’s a quick list:
- Microloan – usually for sums that are less than $50,000. In most cases, microloans carry a higher rate of interest than loans for a bigger amount.
- Small business loan – this type of borrowing can often be the best choice for an entrepreneur. A small business loan is usually available at a reasonable rate of interest and for terms that range from two to five years.
- SBA loan – the U.S. Small Business Administration (SBA) is a government agency that provides support to the nation’s entrepreneurs. SBA loans are among the cheapest in the market, but it can be difficult to qualify for one.
- Business credit card – these can provide you with a flexible source of finance. Business credit cards are also popular because many of them give you additional benefits like hotel room upgrades and discounts when renting a car.
- Equipment financing – if you need to buy new machinery for your business, equipment financing could provide a good option. Many manufacturers offer equipment finance for the machinery that they sell.
- Line of credit – opting for a line of credit is a good idea if you are not sure when your business will require funds. The main advantage of this type of finance is that you are charged interest only on the amount that you use. So, you can get a line of credit approved and wait to use it only when you need the funds.
- Merchant cash advance – borrowers don’t require a good credit score to get approved for a merchant cash advance. That’s because the lender provides a cash advance against your future credit card sales.
- Alternative sources of capital – if you have launched a new business and have difficulty in getting approved for a loan, consider the alternatives to a business loan. Entrepreneurs can consider borrowing from family or friends or even taking a home equity loan.
Pros and cons of financing your business with borrowed money
Growing your company with borrowed funds can be a good idea. But taking on too many loans has its share of pitfalls. Let’s analyze the debt vs. equity question by considering the pros and cons of using borrowed money in your business.
- It can build your credit – if you make your repayments promptly, it will help to build your credit score.
- You maintain a relationship with your banker – you could consider borrowing a small amount of money even if you don’t require the funds. This will help you to build a relationship with the lender, an association that could prove to be very useful when your business is short of funds.
- It can help you to expand rapidly – borrowed funds can give you the extra cash that you need to convert your ideas into reality.
- It can boost your profits – consider a situation where a business owner borrows money to buy new equipment. The money that is earned from the sale of the products manufactured using the new machinery could be used to pay off the loan. Without borrowed funds, it wouldn’t have been possible to earn the extra profit.
- Interest costs – this is the biggest drawback about borrowing money. Of course, you need to pay a fair rate of interest. But unreasonably high costs can eat into your profits.
- The need to provide collateral – some lenders insist on a property or other asset being offered by the borrower to secure the loan. This can be a deal breaker for a small business owner who can’t provide collateral.
- Delays – many lenders take weeks or even months to provide approval. SBA loans can take unusually long to approve.
- Time, effort, and expense – preparing a loan application will require you to collect your financial statements and other relevant information for the last two years or more. You may also need professional help to get your documentation in order and to assist with the paperwork.
How much should I borrow to invest in my business?
If you have answered the debt vs. equity question by choosing to go ahead with borrowed funds for your business, the next issue that you will have to address is to decide on how much to borrow.
The first step that you must take is to figure out how much to invest in your business. It’s advisable to take a step-by-step approach:
- Define your business goals.
- Decide on how much investment will be needed to meet each goal.
Remember that you must not over-borrow. Taking on too much debt can land you in trouble. Here’s a rule of thumb that you can follow to decide on a maximum borrowing limit. The monthly repayment on your loan should not exceed 80% of your net profits. This will provide you with a cushion in the event of a decline in your cash flow.
You can use a business loan calculator to check that your calculations are correct.
Tips to borrow money to finance your business
How have you answered the debt vs. equity question? If you have decided to go ahead and borrow money, there are a few precautions that you must take:
- Don’t overborrow – it can kill your business.
- Make sure that your business can generate enough cash to repay the loan that you take.
- Use the borrowed funds for your business. Don’t invest in non-productive assets.
- Select your lender carefully. The wrong choice can lead to high-interest costs and lower profitability.
Borrow wisely – choose Camino Financial
If you have decided to borrow funds for your business, make a start by applying to Camino Financial. The application process will take just a few minutes, and it won’t impact your credit score.
A loan from Camino Financial beats self-financing as well as external financing. The benefits you get include a free, no-obligation consultation with our business loan expert. Here are some of the other advantages of a loan from Camino Financial:
- Repaying your installments in time will help you to build your business credit.
- The funds that you borrow from Camino can be used for various business-related purposes.
- The loan amount ranges from $5,000 to $400,000 to fit any of your business needs.
- You don’t need to provide any collateral.
- The loan process is simple, straightforward and entirely online: this will save you the paperwork and the visits to the bank.
- The application process is fast and. You will receive your funds within 4-10 days.
- You will need to make repayments in fixed monthly installments. This ensures that you have complete predictability and control over your finances.
Take the first step by completing this Camino Financial application form. You’ll instantly know if you have been prequalified, and soon after a loan specialist will contact you to guide you through the rest of the process.