Deciding whether you should accept a small business investor’s money or take on a small business loan is a decision that’s rarely clear-cut. You might be familiar with the big-picture differences between these two funding structures, like one requiring a schedule of monthly payments of principal and interest and the other requiring participation in company profits. But, before you move forward with an investor pitch or small business funding, there are many more factors that you will need to think about.
Here, we’ll discuss three important things you should think about when choosing investors or a loan.
What’s the difference between small business investors and small business loans?
Your decision to take on a business loan or money from small business investors ultimately comes down to choosing between mitigating risk and keeping more of the earnings from your business. Let’s take a look at what’s involved in each option.
Investors: When you receive cash from investors, you exchange part of your business and rights to the business’s profits.
Loans: When you receive a business loan, your lender is providing cash to your business in exchange for that cash to be repaid with loan payments and interest. The lender doesn’t own your business and have any right to your profits.
Personal guarantee makes a difference
The personal guarantee is what makes the risks and rewards of choosing investors versus business loans a fair trade. When you decide to fund your business with small business investors, you are agreeing to earn less of the company’s profits in exchange for spreading the risk of starting the business around with your other investors.
Here’s where the personal guarantee comes in: when you decide to take on a business loan, not only does your business promise to pay the money back, but you also personally promise to pay the loan back by signing a personal guarantee. So, when you decide to fund your business with a loan you’re deciding to keep all the business’s profits in exchange for personally taking on all the risk. As a result, the personal guarantee makes the tradeoff of “give me all the risk and all the reward” equal to the alternative of “give me less risk, and I’m willing to take less of the reward.”
Equity and debt are suited to different situations
How you plan to use the money is another important factor in making your financing decision. Loans and investors are suitable for their own unique situations. Let’s look at how these options fit into different scenarios.
Inventory and short-term working capital:
When your business needs funds to buy new inventory or to pay for regular expenses while waiting to be paid by clients, these are short-term working capital needs. Accordingly, investors aren’t the best fit for this situation.
Here’s the reason: if you’re buying inventory you probably plan to sell it quickly (making back what you paid), and then you’ll likely need cash again when you need to buy more. For this reason, it doesn’t make sense to raise money from investors because you’re trading a long-term, expensive commitment for a temporary cash need. A term loan or line of credit would be a more appropriate source of financing for this need.
Research and development:
Developing a new product, service, or a new way of doing business involves more risk and patience than starting a business concept that has been proven successful many times before. Oftentimes these ventures take longer to get started, but in the long term, they have the potential to produce much more in profits than other less innovative projects.
Loans aren’t the greatest fit for this type of capital need because the repayment period will likely begin before your business starts to see proceeds from this initiative.
With funding from investors, you’ll be able to spread the risk of that long wait to launch the concept. Investors are rewarded for taking a chance in developing your new concept by the big reward that could potentially come from its success.
Construction, furniture, fixtures, equipment, and startup costs:
Construction, furniture, fixtures, equipment, and other one-time or start-up costs are costs that create or enhance the value of a company. By paying for these items, the business levels up and can potentially earn more money.
You can use financing from investors or loans to fund these investments. It will likely lead to larger profits to share with investors in the future. With longer repayment terms available on loans, your future cash flows from enhancing the business will be able to cover the repayment cost.
Most small businesses that seek investor funding find it from individuals — people who don’t publicize their status as an investor. They invest in projects that matter to them, can give a decent return, and tend to give financing to people they trust.
What type of access do you have to potential investors? Consider whether you have a network, or if you can build a network, that would lead you to individuals who are compatible to your project and interested in being an investor. If not, you may need to explore options for business loans.
There are many projects that combine funding sources from both investors and lender. In these situations, you can match each funding source for the most appropriate part of your project. For example, investor funds could be used for developmental aspects of the project, and loan funds can be used for fixed costs.
Carefully consider the risks of this type of arrangement, as you may be required to both be the sole personal guarantor for the project as well as share the profits with investors. In this type of situation, you’ll want to reflect back on all the risks and rewards of the project and decide if this type of capital mix is right for you.
Looking for funding? Pursuit can help
If a small business loan is the right fit for your needs, get in touch with us today. With more than 15 small business loan programs and a range of additional services, we’re committed to helping your small business get stronger today and keep moving forward.
To learn more about how we can help you, contact us today.