Loans or Equity: How to Choose the Best Financing for Your Small Business

Consider the pros and cons of equity versus loan before you decide what's best for your business.

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Many small businesses do not have the luxury of always having all the money they need to operate. When considering where you can obtain outside cash, there are two common options to consider: loans and equity funding. Both sources have their own advantages and drawbacks.

Loans

While it can seem circular, the ability to obtain a loan from a commercial lender depends, at least in part, on the current financial condition of your business. If a lender sees your business as relatively stable and profitable, and repayment of a loan seems likely, then you will have an easier time getting the money you seek. Conversely, if your business seems shaky, getting approved for a loan could be extremely difficult; bad economic conditions only add to the difficulty.

Loans involve collateral, also known as “security,” and that means placing some of your own assets at risk. Be aware that if you default on your loan, the lender not only can go after the collateral you specified in agreeing to the loan, but, as necessary, other business assets—or even, depending on the legal form of your business and the terms of your loan, your personal assets. Therefore, apart from the lender’s risk calculation, you need to do your own risk-benefit analysis. Think as clearly and objectively as you can about the odds of your business’s ongoing success before you sign the loan documents.

If you determine that the risks are acceptable, a loan can often be preferable to equity-based funding, because the lender retains no ownership or control over your business: As long as you pay back the loan, the profits from the business are all yours.

The Loan Note

A key document in most loan arrangements is the promissory note. Simply put, this is a piece of paper that states that you owe the lender a certain amount of money, to be paid back over a certain amount of time, at a certain interest rate.

Make sure you only sign the original note and not any additional “copies;” you don’t want any confusion about whether more than one loan is involved. The note will be kept by the party entitled to collect payment on the note. This is frequently the original lender; however, in some cases, the original lender may negotiate the note to another party. Later, in return for paying off the loan, you should make sure to get back the note.

If you find yourself with the option of getting a loan without a note, here’s a piece of advice: don’t do it. When it comes to lending money, misunderstandings—and disputes—frequently arise. Some disputes can be more costly than the loan itself. It’s safer for everyone—both the lender and you—if you have the terms of the deal in writing. See Nolo's Promissory Note forms for different type of promissory note and loan terms.

Repaying a Loan

There are a variety of ways to structure the repayment of a loan. Most basically, you can either make multiple payments over time (paying in installments), or make a single, lump-sum payment by a due date.

There are various ways to structure installment payments. For example, you might only pay interest over time, and pay back the principal at the end of the loan. Or, each of your payments might combine some payment of interest and some payment against the principal. You should review all your available repayment options before making a final choice.

Equity Funding

Unlike loans, funding from equity comes from people who invest money in your business in exchange for an ownership interest. It is immediately clear how this differs from bank loans, which do not affect business ownership. Different people will feel differently about co-ownership; you should think hard about what your own tolerances are in this regard, as well as about exactly who your investors will be.

Investor Risk

Ideally, your investors want to make a profit—or get some other kind of desirable return—on their investment. But perhaps equally important, they want to avoid excessive losses.

More particularly, many equity investors want to limit their losses to the amount of money they invest. With this in mind, you should be aware that certain legal forms for your business, such as a corporation, limited liability company, or limited partnership, include mechanisms for limiting investor risk in just this way.

Keep in mind that there isn’t just one approach to investor risk. You can, and should, discuss with your investors what level of risk they can accept. However, at the end of these discussions, you should make sure it’s the investors, not you, who make the final decisions on risk. If your business subsequently fails, you don’t want investors coming back to you claiming that they were forced into a certain funding arrangement.

Return on Investment

People become investors in your business because they hope to ultimately get some benefit from the money they are providing. The nature of the benefit—the return on the investment—can take any number of forms. Here are just two examples:

  • You might agree with your investor that, for a set, limited number of years after the investment, or until the investment amount is recouped, you will only be paid a stipulated salary and your investor will receive a high percentage of any profits. After that time, assuming the business is successful, your investor will receive a much lower percentage of profits, with the rest of the profits going to you, regardless of whether you still receive a salary.
  • You might agree with your investor that initially you will be paid a stipulated salary, and all other profits will go to the investor until the initial investment amount is recovered. After that time, you will split profits evenly, regardless of whether you still receive a salary.

Regardless of the specific arrangement, if you have formed your business as a corporation or limited partnership, and the equity funding involves shares or interests in the business, you will want to make sure you are complying with the appropriate securities laws. This may well require consulting with a lawyer.

Which Approach is Better?

There’s no simple answer to this question. Loans are good if you don’t have a problem with putting existing assets at risk, don’t want to dilute the ownership of your business, ultimately want to keep all business profits for yourself—and can meet the lender’s credit standards. Funding through equity investors may be preferable if don’t want to put your existing assets at risk or can’t qualify for a conventional loan.

For additional help in making a decision, check out Nolo’s articles on equity investments and alternative ways to borrow money. For more thorough information, consult Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo).

October 2012

by: , Contributing Author

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