Should Startups Take Out a Business Loan or Seek Investors?

Every small business owner has a vision, but to make that vision a reality, you need capital. Finding funding can be a significant hurdle for new businesses, especially if you're not sure if you should take out a business loan or seek investment in your company.

Navigating types of loans, business loan rates, and cost-benefit analyses of selling an ownership stake in your business can feel like a minefield. There is't an easy answer. Choosing between debt financing and equity financing is complicated, and it's a strategic decision that may shape your company's future. There are compelling arguments for both paths, and the right one for your startup depends on your business model, financial stability, and the ultimate goals for your business and for yourself as an entrepreneur.

In this article:

• Comparing the benefits and drawbacks of small business loans and equity financing.
• Exploring the types of easy business loans for new business that could help get your venture off the ground.
• How to apply for new business loans and pursue investment for your business.

What to Know About Debt Financing

Borrowers will take out a business loan to retain full ownership and control of the company. That's arguably the most important advantage of debt financing. There are many lenders and types of loans that can benefit a small business. Some of the key benefits of debt financing include:

• Full ownership: When you work with a lender, you do't shed any ownership to that lender in exchange for loan proceeds, regardless of the financing option you use. As your business succeeds, you'll reap the rewards without having to pay dividends to other owners.
• Decision-making power: In many equity arrangements, you'll have to cede some decision-making power to investors who expect to have approval rights for major strategic moves.
• Future support: Whether you're working with a business bank or an online lender, establishing a good relationship with a lender may streamline future credit approval and loan options, giving you easier access to capital as your business needs evolve. Take out a business loan once, and it may be easier to do it again in the future.

Types of Business Loans

There are many different types of business loans that can support a variety of business needs. These may include:

• Term loans: With a term loan, you get an upfront lump sum that you repay over a specific loan term. You can use this money to address major business needs or as a buffer for working capital.
• SBA loans: The U.S. Small Business Administration (SBA) works with lenders to partially guarantee business loans. When you take out a business loan through the SBA, you can often expect more competitive interest rates and loan terms, although the eligibility requirements tend to be strict and the approval process is slow.
• Business lines of credit: A cross between a business loan and a business credit card, a business line of credit gives you access to a maximum loan amount that you can withdraw from as needed. You only pay interest on what you borrow, and when you repay the borrowed amount, you'll have access to the full amount again.
• Commercial real estate loans: These loans are designed for purchasing commercial real estate properties.
• Equipment financing: These loans can help you acquire essential equipment for your business, like vehicles or manufacturing equipment. Typically, the equipment itself serves as collateral for the loan, which may allow you to lock in a lower interest rate.

How to Take Out a Business Loan

Loans are available from both traditional lenders, like banks and credit unions, and online lenders. Traditional lenders tend to have stricter qualification requirements, such as a higher credit score, annual revenue, or time in business requirements. They also usually have slower application and underwriting processes, but can offer lower interest rates and higher loan amounts. Online lenders can usually offer faster funding and work with businesses with less credit history, but may have higher interest rates or lower loan amounts.

Regardless of the lender or loan program, the process usually looks like this:

1. Determine funding needs: Before you apply for a bank loan, you'll need to know how you plan to use the funds. This will inform your business plan, which can increase your approval chances and also give you a better idea of what types of loan options to pursue.
2. Compare lenders: Many lenders allow you to prequalify for loans to get an idea of repayment terms and interest rates before you officially apply for small business financing. Prequalifying will let you compare business loan rates and business lending options, so when you do take out a business loan, you'll know it's the right one for your situation.
3. Gather documentation: When you're ready to officially apply for a new business loan, you'll need to gather your financial statements, bank statements, tax returns, and business plan to submit with your application.
4. Apply: The formal application process is usually faster with online lenders, but in either case, the lender will assess your application and, if approved, dispense funds into your bank account after underwriting.

What to Know About Equity Financing

If you have bad credit or you're struggling to get approved for a loan, outside investors could be an intriguing option.

Investors are typically looking for businesses that have a significant opportunity to grow. Venture capitalists (VC), in particular, are looking for businesses with massive potential; they're not likely to invest in a local contracting business because the market opportunity just is't big enough. Instead, it's more likely that small business owners may work with angel investors, friends, or family members who are interested in an investment opportunity. If you're willing to dilute your ownership in the company, investors can be a good way to get capital into your business without having to repay debt or go through a credit approval process.

Some key benefits of investment include:

• No credit approval: Business owners with bad credit or startups that might not otherwise qualify for business loans could get capital if investors believe in the business's profitability potential. That can be easier than trying to take out a business loan.
• No debt: You only pay investors if your business makes a profit, so you do't have to deal with monthly payments cutting into your cash flow.
• Professional resources: Investors can provide strategic value in the form of expertise, a network of industry contacts, and mentorship. They may have worked with startups in the past and could be a great resource for navigating challenges and opening doors to new partnerships and opportunities.

How to Decide Between Debt Financing and Equity Financing

The decision to take out a business loan versus seeking investors depends on a few key questions:

• What are your long-term goals: If you want to build a sustainable, profitable business that you can pass down to your family, then you probably want to avoid diluting your ownership. In this case, you may want to take out a business loan to meet your financing goals. If you just want to build and sell a company quickly, equity financing makes more sense.
• How much control are you willing to give up: Some entrepreneurs want advice and support from people who have been there before. Others want to be completely in control of their own vision. If you do't want to cede decision-making power, then you might prefer to take out a business loan.
• What is your business model: Businesses with consistent, recurring revenue may prefer to take out a business loan since they're financially stable. Lenders will see a path to repayment, and your business can grow sustainably. Highly speculative ventures that do't guarantee immediate revenue may only have investors as a realistic option.

Final Thoughts

Ultimately, the choice between debt financing and equity financing comes down to your personal risk tolerance and your vision for the company. Both paths have their own set of risks and benefits. To take out a business loan offers autonomy and financial discipline, while investors can provide strategic expertise and debt-free capital. The right choice is the one that best aligns with your vision for the company and your values as a business owner.

FAQs About Taking Out a Business Loan

Which is better for an early-stage company: a loan or investors?

It depends on the business. Those with predictable early revenues make take out a business loan to get started and retain full ownership of the business. Pre-revenue companies may not qualify for loans, but the potential of their idea could attract investors.

What is the biggest risk of debt financing?

The biggest risk is being unable to repay the loan. Lenders can charge penalty fees that can put a significant strain on your finances and, in the worst case, lead to bankruptcy.

What is the biggest risk of equity financing?

Investors often get a seat on your company's board and have the power to influence or even veto major decisions. Long-term, this could present a risk to your control over your own company.

Can I do both equity financing and debt financing?

Businesses can choose to take out a business loan to get off the ground and pursue equity financing to accelerate growth later, once they have a solid revenue track record.

How do I know if my business will get approved for a loan?

Lenders generally look for a few key things: a strong personal credit score from the founder, a clear and well-thought-out business plan, and a path to predictable revenue. Businesses with collateral, a down payment, or assets that can be used to secure the loan are also often viewed more favorably.

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