February 7, 2014 | Case Study , Loan Purpose

Debt, the Equity Alternative

Deciding between equity and debt financing is a challenge many new small business owners will face.

A loan can be an important part of how you stabilize and grow your company. The decision to obtain a loan adds a significant element to managing your business.  It’s crucial you fully understand the advantages, disadvantages and obligations that come with borrowing before you apply for a loan.

What to Expect

The relationship you have with your investors or business partners is based on their belief in your abilities and the potential value of your product or service.  As such, they accept the many uncertainties that exist for small business owners.  This risk is accepted in exchange for the reward of future returns. If for some reason your business fails to become profitable or you are unable to return their capital, your investors will incur a financial loss and perhaps emotional distress but rarely will you have legal consequences.

Lenders, however, do not share the same enthusiasms about your business.  Although a lender will base their credit decision on their opinion of the potential success of your business, their primary concern is your willingness and ability to repay your loan. Often, the lender will require you to sign an agreement, in addition to your company agreement, to personally guarantee the loan in the event the company defaults on the loan.  Unlike a typical investor, a lender has legal recourse to collect on their debt from you and your company.

Not everything is bad when adding capital to your company using a business loan.  Your lender is not an investor thus they do not intervene in the day-to-day management of your business. Lenders refrain from offering suggestions on how to market or manufacture your product. Lenders are, however, exposed to many businesses and can serve as a great resource for you to gain insights on business issues and industry trends.

Perhaps the best advantage of using debt is that current shareholders will not be diluted.  Once a loan is paid off, say goodbye to your lender.

When Does a Loan Make Sense?

A small business should consider a loan once they have developed their product or service, established basic operations and made some initial sales.  Borrowing too soon may limit or constrain your ability to raise capital from investors.  Early stage companies can sometimes believe in the illusion that a loan is income.  This is a dangerous notion that could lead to ruin for any company.

Commonly, a new business will decide they need a loan too late.  This can lead to poor decision making.  You may end up with a loan that cost too much, does not provide you with the amount you desire or funds later than you need.  A good exercise for all companies, even those not anticipating a short-term need for a loan, is to make contact with lenders to learn about what loan programs are available and what is the process to apply.

The decision to apply for a loan should be made after careful analysis and consideration of the current and future financial performance of your company.  You must be confident that your company will generate enough revenue in the future to cover both your expenses and loan payments in addition to providing you with income. If you do apply for a loan, take the time to understand every term and condition of the loan. You should never hesitate to ask your lender a question.  And remember, a loan should only be taken out if it helps your business grow. Otherwise, do not borrow.