In practice, most businesses use a combination of debt and equity financing. The trick is getting the right balance. If you have too much debt, you may overextend your ability to service the debt and can be vulnerable to business downturns and changes in interest rates. On the other hand, too much equity dilutes your ownership interest and can expose you to outside control. The mix that best suits your company will depend on the type of business, its age, and a number of other factors. For a small business, a local community bank will consider an acceptable debt-to-equity ratio to be between 1:2 and 1:1, although debt ratios vary significantly from industry to industry. Startups and newly launched firms will likely be heavily weighted toward equity since they have not had time to establish a credit history and may face negative cash flow in the early years. Whatever your mix, keep in mind that you can often negotiate terms with both lenders and investors, making debt more like equity and equity more like debt.
• Since debt and equity are accounted for differently, each has a different impact on earnings, cash flow and taxes, and each also has a different effect on leverage, dilution and a host of other metrics.
• Debt can be a loan, line of credit, bond or even an IOU — any promise to repay borrowed amounts over a certain time with a specified interest rate and other terms.
• When you finance with equity, you are giving up a portion of your ownership interest in — and control of — the company in exchange for cash.
• While equity financing can be used for many different purposes, it is usually used for long-term general funding and not tied to specific projects or time frames.
• The mix of debt and equity that best suits your company will depend on the type of business, its age, and a number of other factors.
• “Crunch the numbers” to figure out exactly how much your business could realistically afford to spend on debt repayment each month.
• Be prepared to provide a detailed overview of your company’s assets. Lenders will want to know what type of collateral you have.
• Hire a lawyer to review the terms of the financing strategy you’re considering.
• If your personal or business credit reports contain any incorrect negative information, correct it immediately.