It’s important to understand the differences between debt and equity finance when deciding the right way to finance your business.
Researching your many options for funding your business can be time consuming. If you’re looking to start a business or take the next step and expand, you have the option of debt or equity finance.
Here are some key things to consider when deciding if debt or equity finance best suits you.
How much do you need to borrow?
The first thing you need to know is how much money you’ll need. You can get an idea of this through a number of different methods:
If you’re starting a business – add up your set-up costs such as rent, equipment, shop fit-out, inventory, wages and super contributions (including your own), legal and accounting costs.
If you’re purchasing an asset – ask for a copy of the contract with the purchase price.
If you’re borrowing for cash flow purposes – use cash flow forecasts to identify any shortfalls. The CommmBank financial plan template includes a cash flow template you can use to do this.
By comparing this amount to the cash you have available, you can gauge how much money you may need to borrow. To reduce financial stress, if it looks like you need to borrow a larger amount, you may want to consider ideas that can save you more money or, if you can, keep working your existing job for extra income.
Another option can be to apply for federal government grants for some new businesses.
Debt finance is borrowed money that you pay back with interest within an agreed time. The most common types include: Bank loan, Overdraft, Mortgages, Credit cards
Equipment leasing and hire purchase.
Advantages of debt finance
You have control over your business and assets as you don’t need to answer to investors
You don’t have to share your business profit
Some interest fees and charges on a business loan may be tax deductible – your accountant can advise you on this.
Considerations for debt finance
New businesses may find it difficult to secure debt finance without accurate financial records or projections and a comprehensive business plan
You’ll need to generate enough cash to service repayments, fees and interest
Regular repayments can affect your cash flow. Start-up businesses often experience cash-flow shortages that may make regular payments difficult
If you use an item as security to guarantee a loan, the item could be repossessed should you be unable to make repayments.
Equity finance is investing either your own or someone else’s money in your business. The key difference between debt finance and equity finance is that the investor becomes a part owner of your business and shares any profit the business makes.
The main sources of equity capital are:
Family and friends
Business angels – individuals who invest their own funds (typically up to $2 million) into start-up businesses
Crowd funding – this relies on people to donate money to a business
Venture capitalists – professional investors who invest funds (generally $2-10 million) in operating companies
Public float – raising money by issuing securities (e.g. shares) to the public.
Advantages of equity finance
Freedom from debt and no repayments
Considerations for equity finance
Shared ownership means you may have to give up some control of your business. Investors not only share profits, they may also have a say in how the business is run
Accepting investment funds from family or friends can affect personal relationships
You may have to compete with a number of other business for funding from the same source, making it harder to get the cash you need.