How to Choose the Right Type of Business Financing

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Category: Loans
Posted on: 02/02/2021
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In one of our previous posts, we talked about the different types of business financing options available for small business owners. If you haven’t read it yet, we recommend checking out our business funding comparison to get some context.

Types of business financing available

Knowing your financing options is the first step towards determining what type of financing best works for your business. By taking a top-down approach, you can better tackle this decision. First, determine if you want debt financing or equity financing.

Debt Financing

Debt financing occurs when you borrow money to run your business. You then pay the money back, usually in installments, with an interest charge and/or a fee.

There are many types of debt financing available, including (but not limited to):

● credit cards 

● microcredit loans

● commercial term loans

● lines of credit

● overdraft

These are the most commonly used type of financing by small business owners in Canada and offered by banks and other financial institutions

Equity Financing

Equity financing is a type of funding that gives someone part ownership of your company. This means that you share your company’s profits and sometimes decision-making power in exchange for their investment in your company.

There are many types of equity financing available:

● crowdfunding

● business incubators

● initial public offering (IPO) - stocks

● angel investors

● venture capitalists

Equity financing terms can be much more favorable to a small business owner. However, it’s extremely difficult to get and may require you to give up some control of your company. Investors providing this type of financing usually invest in larger, more established businesses with the expectation of large profit in a short period of time.

Choosing between debt and equity financing

The choice between the two has emotional and financial considerations associated with them. Let’s explore these considerations by looking at two different situations.

Emotional considerations

In debt financing, you get to own 100% of your business and maintain autonomy. That’s ideally what every small business owner wants. Equity financing can be seen as “giving up” a part of the business. This may result in a loss of autonomy and thus may negatively affect how you view yourself.

However, it could be a positive decision for your business. For example, there is a crucial business function that isn’t going well. It could be due to a lack of expertise. But if you get an angel investor who is willing to inject their expertise, along with the financing - this will help your business. 

Financial considerations

By setting emotions aside, you can take a more numbered approach to the decision. For debt financing, start by determining the cost of capital. For example, if you take out a $100,000 loan at 25% interest, then your cost of capital is $25,000. However, interest payments made on some debts are tax-deductible. (Check with your accountant to understand which types of loans are tax-deductible.) Assuming that corporate tax is 30%, then your actual cost of capital is 70% of 25%, which is 17.5%! Meaning, after claiming your taxes, you only pay $17,000 out of the $25,000.

Luckily, you can figure out your previous cost of capital of other loans from your accountant’s financial statements. This historical data can be used as a benchmark for future business decisions. 

Equity financing has a much more complicated method of calculating the cost of capital since there are intangible values involved, such as the expertise or access to resources from the investor. If you are interested in learning more about these complex calculations, you can check out this great post by Investopedia on capital structures

The Bottom Line

To determine the right type of business funding for you, consider whether debt financing or equity financing is the right option for you. Understand that there are intangible pros and cons associated with each type of financing. 

To determine the most cost-effective method of acquiring capital, refer to your financial statements. Your financial statements will show your past cost of capital and provide insights into what worked best for you. Once you have established the cost of capital and considered the emotional impacts, determine which type of business funding is right for you. 

Finance Guru

Finance Guru