Small Business Financing: Debt or Equity or Revenue-Based?

Small businesses are privately owned corporation, partnership, or sole proprietorship that have fewer employees and less annual revenue than a corporation or regular-sized business.

Small businesses often need money, at different stages. A business owner usually considers the two basic types of funding: Debt financing and Equity Financing.

Debt Financing:

Debt financing is essentially a loan that the business owner pays back with interest. This takes the form of a business loan from a bank.

Pros:

1. Business owner retains all ownership control.

2. Interest paid is tax deductible.

3. Easier to forecast expenses as loan payments do not fluctuate.

4. Cost effective in the long run.

Cons:

1. Long approval process with collateral requirements.
2. Fixed payments regardless of the business revenue.
3. Higher risk for businesses with inconsistent cash flow.
4. Can lead to slower growth of the business.

Equity Financing:

Equity financing is a business funding method where a business owner sells a share of his business in return for upfront capital. This usually takes the form of a partnership where the people who provide the funds become partners. These funds are used for immediate business operations or long-term growth. The value of the share is based on the valuation of the business, and partners become part owners of the business. In most scenarios, the partner are not involved in the day-to-day of the business and are considered as passive owners.

Pros:

1. Capital available upfront with no fixed repayments.
2. Partners take a long-term view and understand that growing a business takes time.
3. Sharing expertise and knowledge among partners
4. Potential tax benefits in case of general partnership.

Cons:

1. Profits are shared for an indefinite time.
2. Partial control is given to others partner and important decisions need to be made jointly.
3. Buying the share back from a partner can get ugly and expensive.

Revenue-based Financing:

Revenue-based financing is a method of raising capital for a business in exchange for a percentage of the gross revenues. The revenue is shared until a predetermined amount has been paid which is usually higher than the initial capital raised.

Pros:

1. Retain More Ownership & Control
2. Cheaper than equity in the long run.
3. Shared Alignment Towards Growth.
4. No Personal Guarantees or collateral required.
5. Faster funding process

Cons:

1. Not a good match for businesses without revenue.
2. Usually involves weekly or daily payments.
3. Limited availability.
4. Smaller funding amounts.

Deciding which financing is the best fit depends on what you are willing to surrender in exchange for the financing, and on what your business has to offer.

References & Further Reading:

1. https://www.investopedia.com/financial-edge/1112/small-business-financing-debt-or-equity.aspx
2. https://www.investopedia.com/terms/d/debtfinancing.asp
3. https://www.investopedia.com/terms/r/revenuebased-financing.asp
4. https://flowcap.com/pros-and-cons-revenue-based-financing/