Loan vs. Investment: Business Investing vs. Financing
Dec 02, 2021
Investor vs. creditor is a significant question for business owners who are ready to scale. While profitable growth may be the ultimate objective for all business owners, it’s also important to create sources of financial funding that can sustainably support your planned rate of expansion. If you’re planning a fundraising strategy for your business, start by familiarizing yourself with the two most common ways to raise capital for a company. Reviewing the pros and cons of loan vs. investment can help you strategize about the best path forward for your enterprise.
Defining business loans
Is a loan an investment? Not usually, although you can use the proceeds of a loan to invest in your company. Business loan funding you borrow constitutes debt capital. Just like personal debt, you repay this type of capital over time with interest. When you raise capital with this method, you apply for a loan or line of credit for your business and make payments according to the lender’s terms and conditions.
Federally guaranteed loans from the U.S. Small Business Administration are among the most common ways for growing businesses to secure funding. The SBA has several types of business investment loans available, including:
- 7a financing, a flexible loan of up to $5 million to fund both short-term and long-term needs including but not limited to working capital, supplies, and furnishings. You can also use a 7a loan to refinance existing business debt.
- 504 financing to purchase real estate, equipment, supplies, inventory, and other business needs at a long-term fixed rate. These loans have maximum income guidelines.
- Microloans, which provide up to $50,000 to start or expand a business. These funds can be used for most purposes, except for refinancing debt or buying real estate.
SBA loans typically have lower interest rates and more flexible terms than other types of debt capital. Alternative business borrowing options include:
- Business loans without federal backing, available through traditional and online financial institutions
- Invoice factoring, which provides advance payments for a portion of your outstanding invoices
- Business credit lines, which are best for short-term cash needs
- Term loans, which can provide long-term funding for expansion if you can meet the strict qualification requirements from a bank
- Purchase order financing, which provides advance funding based on outstanding orders you need to fill
- Payment plans directly through the vendors and suppliers your company uses
- Bond sales to private investors in exchange for regular monthly payments
- Mezzanine debt, also called subordinated debt, which provides additional loan proceeds beyond traditional loans at higher interest rates
Advantages of business loans
When comparing a loan and investment, independent business owners often prefer debt capital to equity capital because it allows them to maintain control of a business. If your business generates strong or predictable monthly cash flow, taking out a loan can be a great way to finance your growth in a cheap and sustainable fashion.
Advantages of growing your business with loan vs. equity based include:
- Fixed monthly payments toward debt
- Tax-deductible interest payments on many business loans and lines of credit
- The ability to retain sole control of operations and strategic direction
- Fast financing, typically within a few weeks or even days of application
- Generally more affordable than equity financing, which requires you to cede a portion of business profits
Disadvantages of business loans
On the other hand, your business might not be able to repay the debt in the future. Committing the company to excessive debt and, therefore, monthly interest payments can limit your ability to pursue new growth or other opportunities that arise. Some companies may be unable to qualify for a business loan or credit card. For example, SBA loans carry strict eligibility requirements.
It’s also important to understand that if you are new to raising capital for your business and do not have a company credit history, you may need to provide a personal guarantee for loan approval. This means you put assets such as your home at risk if you cannot pay back the loan.
Defining equity investments
Unlike business loans, equity investments do not require monthly principal and interest payments. Instead, you fund your business with a cash infusion from an individual or institutional investor. In exchange, you give up an agreed-upon share of the company’s future profits. Some people call this strategy shares vs. equity. Many investors can also serve as mentors as the brand continues to grow.
To qualify for equity capital, you must illustrate your ability to provide value in the form of future growth. If the company does not grow as expected, the value of the investment will decline. Because of this higher level of risk, the cost of equity capital will exceed the cost of debt for business owners.
Equity capital might be the right route for your business if you need a mentor to guide growth. In addition to working funds, the right partner should have experience in your sector and prepare to have a stake in your success. If you think your company could benefit from this type of input, carefully consider the amount of equity you sell to a potential investor. Giving up more than 50% of business means you’ll no longer have control of the company.
Advantages of equity investments
Advantages of equity investing vs. loan financing include:
- Delayed financial impact of months or even years, unlike debt, which requires repayment almost right away
- Ability to qualify without necessarily having a strong business credit score, cash flow, or collateral
- Guidance and mentorship from an experienced partner who knows what your business needs for sustainable growth
Disadvantages of equity investments
Consider these possible disadvantages before moving forward with equity investments:
- You must give up a portion of the company to your investors, including part of your control of the business and the projected value of your product and brand in the future.
- Conflicts about the direction of the company and other important business decisions can arise when you have multiple owners.
- Equity capital tends to cost more than debt does. In other words, the amount of profit you will owe an investor if the company succeeds as planned is usually higher than the interest you would pay on a comparable amount of debt.
With so many creative ways to raise capital, comprehensive planning can help you create a financial plan that works for your business. You may decide to rely solely on debt or equity capital or combine the two to best suit your strategic objectives and support success.