|Every small enterprise needs business funding at some point or the other. Now, to raise this money, most business owners need to make a tough choice: between taking an SME loan and selling ownership interests to equity investors.
Equity financing is a way business can receive the required funds by selling shares in their business.
A debt arrangement means that a business owner borrows money, to be paid back at a later date, usually with interest.
While both options are viable and legal, it is important that you understand the pros and cons of choosing one over the other.
Debt is usually less expensive than giving up equity
Provided a company is expected to perform well, debt financing can usually be obtained at a lower, effective cost. Equity financing, on the other hand, costs businesses a portion of its revenue forever. While you have zero debt with equity financing, your personal profits are also slashed significantly for a lifetime as shareholders will always be getting a share in your net profits.
So, which is better? Equity funding means sacrificing both current and future value to fill a short term need. With debt, you incur interest costs, but it is temporary and capped.
Debt can be cheaper than opportunity cost
Sometimes, a small business needs SME loans to grow its operations but is able to attain it only at an absurdly high rate. Even then, if the return on investment is forecasted high, that business funding can be a strategically favourable choice for a businessman who wants to open up new growth channels. Always remember, whenever the return is higher, the debt is worth it.
Paying interest on debt reduces the tax burden
The tax system offers an advantage to financing capital expenditures through debt. Under the current tax law, businesses can deduct their interest payments on the debt instruments. This reduces the tax applicable on any new business.
This, unfortunately, is not true of equity financing which is actually taxed twice.
Debt encourages discipline
Discipline is important in any business. SME loan boosts discipline by regularly matching cash flow with financial statements and balance sheets. When a company opts for business funding, its business operations are routine and unnecessary expenses are held back.
Debt funding can be used as a strategic tool for growing a business. As seen above, it is often a much cheaper financing option than equity financing, which usually ends up taking a larger share of your business’ profits than a bank or other lender.
Take an informed decision; weigh the pros and cons of both in order to keep your business growing.
** By association with Digikredit Finance Pvt Ltd., an NBFC, which operates under the name SMEcorner and offers credit to small business owners.
Originally published in SME Times India