Debt and equity are both tools that the entrepreneur has at his or her disposal when it comes to growing the business. But that is where the similarity ends. For example, where debt works best for one kind of company, equity works better for the other.
Understanding their respective fit is a critical determination for the entrepreneur. So, let’s explore that fit.
If you have what is commonly called a lifestyle business, where you are happy to draw a good salary from the company, then equity may be a better fit. For example, let’s say you are a single-person consultancy. You can give somebody equity in your business, and it’s not going to affect your salary. Again, equity is preferrable, because it doesn’t impact your income.
However, if you are trying to grow the value of your company, then typically, debt is cheaper. That’s because it doesn’t affect the value of your business. However, there is a caveat, especially for the growth-focused entrepreneur.
First, your business may hold potential, but it may not have enough of a track record for a traditional financial institution to embrace it for lending purposes. For example, perhaps your business is unprofitable, but it holds great promise. Banks don’t loan money based on promise. But venture capitalists and angel investors sure do.
Second, you may be able to secure debt, but there are investors in your community that have a great deal of subject matter expertise and/or connections to offer your business. In this case, raising equity may offer a greater return in the long term than debt, since the investors could greatly enhance your valuation.
Finally, financial institutions may be willing to loan you money, but not enough to prove that your business can be successful. In such instances, equity may be a better option.
A final word of caution: You have to be careful if you are combining these investment activities, as they can positively and negatively affect each other. For instance, if you are raising equity and have a ton of debt, then you may not be able to raise the equity, because those equity investors don’t want to be responsible for the debt.
Another consideration: Do you have the ability to be flexible down the road? Or are you really selecting kind of a destiny-type outcome? Like, this is the way it is going to be.
The bottom line? Understanding what your objectives are before exploring investment options is a critical requirement to your eventual success.