Is borrowing money better that giving up equity?
Most entrepreneurs need money in the first years of their businesses and often, this doesn’t happen organically through their activity. They require external working capital. Either borrowing money or by selling a part of your business (giving up equity).
Throughout history, entrepreneurs have been financed by family and some have reached out to banks or investors. Some you have probably heard of and some might be new to you. For example:
- Amazon.com: Founder Jeff Bezos got a $100,000 investment from his parents to start the famous online store.
- SpaceX/Tesla: Elon Musk’s first company Zip2 was founded with $28,000 of his father’s money. That sold to Compaq for $307 million and $34 million in stock options and set Musk on the path to creating X.com/Paypal, SpaceX, and Tesla.
- GoPro: Nick Woodman’s parents, (father is co-founder of investment bank Robertson Stephens), lent him $235,000 to get started.
- Poundland: The UK’s massive dollar store chain began with a £50,000 investment from founder Steve Smith’s father.
- Squarespace: Founder Anthony Casalena received $30,000 from his father in 2003 to build his all-in-one web publishing suite.
It is difficult to predict whether these companies would be the giants they are today without having the cash in the early years of development.
The real answer is always subjective to your own business, industry and your own risk aversion. In most cases, depending on your business plan you either want to grow really fast, you want to build up your business gradually or you want to overcome a plateau.
Debt is cheaper than giving up equity
When looking for working capital for your business, giving up equity is almost always more expensive in the long run than taking on debt.
Giving up equity means that you’re sacrificing future profits indefinitely to fill a short to mid-term need. With a business loan, you incur interest costs, but it is temporary. Once you pay it back, your equity remains intact.
Paying interest reduces tax burden.
Many entrepreneurs don’t know that, in some countries, the cost of interest reduces your taxable profit and, therefore, reduces your tax expense. The effective interest you’re paying is lower than the nominal interest because of this.
It is this lower cost of capital that should be factored in when calculating the return from taking on debt. Small businesses, too, can use it to improve their company’s finances.
Debt encourages discipline
Debt brings with it a discipline about spending and investing that can help your company, especially in the early years of your company.
We don’t think businesses take on debt just to increase your discipline, you can consider this a positive side effect of taking on debt.
The motivation to optimize every pound vanishes when you have a lot of cash to burn. Excess psychology is a threat to small and medium-sized enterprises, which need to continually improve their focus and stay agile. Having big budgets makes it easy for business spending to go from necessities to nice-to-haves. However, when cash is tight, the bar for spending is higher because each decision and transaction must be financially justifiable.
In most cases, this creates a change in the cultural expectation throughout the business. This makes every employee take ownership and responsibility for squeezing the most value out of each stage of production.
There are many situations when it doesn’t make sense to get a business loan. However, if you go about it the right way, it isn’t anything to be afraid of. On the contrary, it can be used as a strategic tool for growing a business and is often a much cheaper financing option than the alternatives. Due to the competitive environment today, more than ever, you must be savvy about using all the tools in your arsenal to help your business reach its full potential.