Loan or equity? How to fund your business
At the heart of the decision to either go for a loan or raise money through equity is the actual need.
For businesses, raising funds has always been quite a task, but even before the entire process starts, an entrepreneur has to figure out which route to take. The toss is primarily between tapping the debt route by taking a loan or raising money through the equity method.
What is debt financing? Debt financing is when you borrow money from a lender and pay it back over a period of time with interest. The most popular method of debt financing is when you take a loan from a bank or NBFC. What is equity financing? Equity financing happens when you sell shares or a stake in your business in lieu of money or capital. This is a popular method of raising funds for startups and angel investors, VCs and PEs are quite active in India. At the end, the choice between debt or equity is dependant largely on the following.
What you need it for- At the heart of the decision to either go for a loan or raise money through equity is the actual need. Certain aspects of a business that need money are best tackled by a loan and others through equity. For example, if you have to buy a piece of machinery for your business and need money to the purchase, a bank loan would be the most suitable way. Banks have lucrative products that are meant especially for such asset finance and can work out the best for the business. The rate of interest on such loans are not steep since the asset being purchased serves as collateral. However, if you need money, for example, to expand to new geographies or market, the sum needed may be considerable. In such cases it may be difficult to get a loan that fits your requirement and the interest to be paid would also be considerably higher. It would be prudent to give away equity in the company for the money needed and make the investor a stakeholder in your journey. Given the equity route does not have the pressure of paying EMIs every month, a business owner has the flexibility and ease of concentrating on his business.
How much you willing to give – The fundamental difference between raising money through a loan and getting it through the equity route is the change it brings to the ownership structure of the company. Taking a loan is pretty straightforward where there is no change in the ownership of the firm and the financial institution extending the money is treated as a creditor. Raising money through the equity route is, however, akin to getting a new owner on board the existing structure. A percentage share of the company in exchange for money is what is at the heart of this transaction and hence it becomes important for the business owner to decide how much stake he or she is willing to give for the money on offer. Ideally, no business owner wants to give away too much stake and hence it depends on what each party can negotiate.
Building business profile- Both debt financing and equity can build the profile of a business, although in slightly different ways. When you raise a loan from a bank, you start building your relationship with it. Over time on the basis of your timely payment, your transactions and profile, the bank may start offering you other services and products. Offers like a line of credit can prove to be very beneficial for a business. On the other hand, when there is cash infusion through the equity route, the business is seen by others through a different prism. It is given that any stakeholder that extends money for equity would have done their due diligence and be convinced about the future of the business. This helps a business in attracting more equity capital into the business if it feels the requirement in future.
Collateral – Most banks and financial institutions require collateral as a security to extend a loan. The value of the collateral provided should be commensurate with the loan extended or else a bank may hesitate in extending the funds. There are different Government schemes like CGTSME that enables a small business to take collateral free loans, but in reality it may be tough to get the desired amount without any collateral. Hence, if the business does not have any collateral to extend, it may be better to explore the route of equity financing.
Age of your business – If you are relatively new in your business or starting up, debt financing may not be easily available for you. Banks often are more comfortable with businesses that have been in business for a few years and have some sort of proven track record. If you are a startup, equity financing may be the most suitable way.
(The writer is the CEO, Wishfin.com)