Debt or Equity, Part 1

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When you get serious about raising capital for your business (and anytime you need cash, it's serious), consider two major avenues:

Debt financing means borrowing money for a fee. Debt financing is ideal, for example, when you don't want to dilute ownership of your business in exchange for the cash you need. Of course, on the downside, you have to repay the full amount of the debt plus interest at some point in the future. If the debt exceeds your ability to pay it back on schedule, you may be forced to liquidate assets or go into bankruptcy.

Equity financing means selling a piece of your business in exchange for a cash investment. Equity financing is great if you don't want an obligation to repay a lender, but, on the downside, you have to give up a portion of your ownership in the business. Give up too much ownership, and you may lose control of your business.

So which approach is better for your company? The answer to that question varies depending on the goals that you have for your business, the ability of your firm to repay its debt, the amount of money needed, and many other factors. Each approach has its good points and its bad.

Many companies utilize a combination of both kinds of financing, maintaining a balance between the two. A business with a line of credit, automobile leases, and an assortment of trade credit and short-term loans (all forms of debt financing) may, for example, look to venture capitalists for an infusion of cash to fuel expansion, offer stock options to its employees, or float an initial public offering (IPO) of its stock (equity financing options).

A company that doesn't use debt financing at one time or another is rare. You can find plenty of different ways to use debt to fuel your business. Here are some of the more common types of debt financing, just to give you a taste of what's available:

Short-term commercial loans
Long-term commercial loans
Home equity loans
Working capital lines of credit
Leasing
Credit cards
Accounts receivable financing
Inventory financing
Corporate bonds
Letters of credit

Be careful about the extent to which you use debt financing in your business. Too much debt piled up against your available assets creates an unfavorable debt-to-equity ratio (which reflects upon your ability to repay your debt and can provide a clear warning sign to potential lenders generally a debt-to-equity ratio in excess of 1 is considered bad). Not only that, but putting your company too far in debt overextends your resources, making it more difficult to weather a downturn in sales or unexpected events that impact your business in a negative way.

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