In an ideal word, you would be able to start your business with your savings or maybe a gift from your father or mother. You would get to profitability before the money runs out and reinvest those profits to grow your business. In this scenario, you maintain 100% ownership and you do not have expensive debt to finance. Unfortunately, for most of us, we need to take some outside capital grow our businesses. But how should you do it? Debt or equity?
First of all, what is debt? Debt is money that the investor expects to get back, in a fixed time period, with interest. If your shop fails, debt holders own your leftover inventory and can sell it to get their money back.
Equity financing is when you sell a piece of your business to somebody else. If they buy enough of it, they may also be buying a vote in major management decisions. They are now your partner; if the business fails, they lose everything, but if you succeed, their upside is limitless.
There are three questions you have to ask yourself when making the choice.
The main differences between debt and equity is that you are legally obliged to pay back your debts. Let’s say your business processes corn for animal feed. You cannot keep up with demand. You need money to buy more corn to increase production. In this case, both debt and equity are options. If you know with some certainty an investment of x will increase my profits by y and “y” is larger than the interest you have to pay, then debt might be right for you. If there is uncertainty, equity may be your only option.
With debt, you are buying money. You can think of it as the same as any other input in your business. When you buy Milo powder to restock your store, Nestlé does not get to control what other products you sell or where you place the packets in your shop. With equity, you are selling a piece of your business. Investors are now owners of your business, just like you. If they end up owning more than half of your company, they may even be able to fire you from the company you started. But giving up control is not only bad. Investors can be very experienced and by sharing control with them, you may be able to grow your business better.
It’s easy to know the cost of money. You can go to a few banks and get their interest rates. It can be hard to know the value of your company. If someone invests GHC 10,000, how much of your company have they bought? 5%? 15%? It comes down to negotiation. If you choose to raise equity, the value of your business and the number of investors who want to give you money decide the price. Before raising equity, make sure you have some bargaining power.
In short, with debt, you will take on less money, that money costs something and you have to pay it back, but you still own 100% of your company. With equity, you do not have to pay the money back and so can invest profits back into the company rather than paying off your debt. This leads to faster growth. But, you are also giving up ownership and investors can take advantage of their power to give you an unfair deal. In either case, the more information you have, the better your decision will be. We recommend that you have at least 6 months of financial records before thinking about taking in outside money. Using a tool like OZÉ will help prepare you for this big business decision.