April 29, 2014 | 5-minute read (961 words)
Guest post by Nik Milanovic of Funding Circle USA.
Starting a business isn’t easy – it often takes a combination of grit, know-how, and luck to get a successful new venture off the ground. Add to that all the expenses that go into launching a business and you have a big challenge on your hands. Yet, depending on how you define the term, small businesses make up anywhere from 90% to 99% of employers in the US. So how do people find the money to launch a new company?
For entrepreneurs who don’t have rich benefactors or outsized savings, there are normally two options: taking out equity or taking on debt. Garnering an equity investment means selling a piece of the company for startup capital, to be paid back out of the returns the company makes when it becomes successful. Debt – or loans – provide the same initial investment, but normally with a finite payback period – the business owner pays fixed installments over time until the principal and accumulated interest are paid off.
So which is better? Should you be rushing out to find angel investors or should you be going to your local bank? What are the pros and cons of each type of funding?
The answer is: it depends. A good rule of thumb to remember is that debt is normally much more expensive in the short term; but taking on equity tends to be more expensive in the long term. A business that isn’t going to see any revenue or returns for a while will normally seek out equity financing, whereas a business that generates cash flow more quickly will be a better candidate for a loan.
Equity normally comes from three different groups: friends and family, professional investors, and institutions. Entrepreneurs who go out and raise money from their close friends and family in exchange for a share of the company’s returns normally have an easier time sourcing the capital – no lengthy business plans, no pitch meetings, no difficult contracts. But going into business with your friend’s money is dangerous – a lot of great relationships can be jeopardized by mixing in borrowed money. Professional investors, often referred to as angels or angel investors, are a nice middle-ground between going to friends and going to an investment firm. Angels are typically rich individuals who want to reinvest their earnings as “seed capital” (so named because it helps a business grow from a ‘seed’) in small businesses. Most large cities have formal groups of angel investors. Finally, institutional capital can normally be raised from private equity and venture capital firms. Because these firms have the most capital to invest, their terms will normally be the strictest and they will have the highest bar for investment.
Debt, on the other hand, more frequently comes from institutions like banks or alternative lenders (though people often do lend to each other, these types of loans are a lot harder to manage without help from a good lawyer.) Banks and other lenders provide many types of debt, such as lines of credit that can be drawn down at any time, merchant cash advances which take a percent of a company’s earnings, or term loans which are paid back at a fixed rate. For the purpose of this comparison, we’ll look at a simple term loan. Equity raises for businesses are pretty inexpensive early on – a business owner can go out and fully fund her company without having to pay back a dime until it becomes profitable. When a business starts generating returns, equity quickly becomes very expensive for the business owner. In its simplest form, an equity investment looks like this: a business owner sells a 25% stake in his company for $1,000,000. He uses that money to build the business over time, and in 10 years his company is worth $20,000,000. He then sells his business, keeping $15,000,000 of the total value – a great result for the owner and a great investment for the equity investor. But even though everyone wins, the business owner still ends up shelling out $5,000,000 that he could have otherwise pocketed.
Now consider a debt investment. It's more expensive early on but much cheaper in the long run. If the same business owner takes out the same $1,000,000 as a loan to fund his company, with a 15% annual rate and monthly payments, he will pay back $1,936,020 over 10 years. The downside is that, with many term loans the business owner will have to make those payments much earlier (although bullet loans only require the principal and interest to be paid back at the end of the loan’s life.) But at the end of the day, that steady payment stream means that the business owner will save $3,000,000 by taking out debt instead of equity.
That is why it makes sense for committed entrepreneurs with solid plans for growing their businesses to consider all their funding options before making a choice. At Funding Circle we think that a good lender can provide the best vehicle for business owners to get the financing they need.
Nik Milanovic is a Senior Analyst at Funding Circle USA, a web-based lender focused on small and medium businesses in the United States, providing loans of $25-$500K to high-quality entrepreneurs looking for expansion, capital, equipment purchase, or more general needs. If you have questions about lending or have any tips we can pass along to small business owners, contact Nik at email@example.com!