Financial resources are a necessity for startups, or any business for that matter, looking to grow. There is a difficult decision that startups need to make on how to finance their goals for future growth. Debt and equity are the primary forms of financing for businesses. Bootstrapping is an alternative that is covered in our article on Bootstrapping found here.
Debt: Borrowing money that needs to be repaid to the lending institution, typically with added interest.
Forms of debt include: mortgages, loans, and credit card debt.
Equity: Selling interests in your company for shares of potential profits.
Forms of equity include: common stock, preferred stock, treasury stock, retained earnings, and capital surplus.
The Pros of Taking on Debt
The word debt terrifies many entrepreneurs because of its negative association with failure. In a business setting, debt can be a way to leverage further resources to accelerate growth, while maintaining control over your company. There are four pros when taking on debt:
- Future Profit Retention: When you take on debt, as opposed to equity, there is no demand on future profits of the business. The business owner only repays their debts plus agreed upon interest.
- Easy Repayments: Unlike shareholders, withdrawing shares when required, the interest affiliated with debt and the debt itself are consistent and can be paid at regular intervals. This regulation lowers unanticipated withdrawals and keeps control within the business.
- No Shareholders Duties: Equity requires maintaining regular meetings and fulfilling obligations with shareholders. This is not required when taking on debt, all decisions remain yours, and you have extra time to focus on your business rather than informing shareholders.
- Tax Return Deductions: As long as the debt is secured through a financial institution, ie. not accrued credit card debt, the interest affiliated with the debt can be deducted from the business’ tax return.
The Cons of Taking on Debt
While debt is not always a bad thing, it is not always positive either. There are cons associated with taking on debt that require some thought as well:
- Debt Servicing: All debts must be repaid and depending on the principal investment and interest rates associated with the debt, the costs of paying back, or servicing, the debt may be high.
- Collateral: Collateral is usually required when taking on debt to finance your company. Collateral lowers the risk on the side of the financing institution but may be unfavourable to entrepreneurs. A mortgage is a form of collateral as the financing body will take and sell the property to be used against the repayment of your debt in the instance you are unable to service your debt.
- Higher Risk: The more debt a company takes on, the higher the risk. This risk increases as the chances of being able to repay a larger sum of money decrease. In order to reduce risk, some businesses take on both debt and equity. The comparison of debt to equity is called the debt-equity ratio which can be used to assess risk in a business investment. Debt is not unlimited.
A company or startup that uses no debt to leverage their opportunities may be missing out on growth possibilities. In general, you are not limited to one type of financing. You can take on both debt and equity over the course of running your business. If you have a mix of both debt and equity financing you are able to establish a debt-to-equity ratio. Your debt-to-equity ratio can determine your company’s risk. To determine if your debt-to-equity ratio is within the healthy range you can use tools like BDC’s Debt-to-Equity Calculator. A result that is 0.4 or lower demonstrates low risk.