Fundamentally there are two broad categories of funding you can use to start up your company. These categories are not distinguished by who you’re borrowing from but by the requirements, limitations and types of returns that regulate the type of investment. It boils down to what you’re giving away to receive the money.
Debt is basically a loan that will need to be paid back, with interest, over a period of time. For example, you need $10,000 to start your business, and your Uncle Buck lends you the $10,000 at a 10% interest rate with a five-year term. That means you pay back Uncle Buck every month a portion of the $10,000 along with interest for five years, until the loan is fully repaid.
Sometimes you may have to personally guarantee a loan – or a portion of it – if you’re starting a business. For example, a loan from a bank or a credit union may require that you do this to protect their loan. This is common, so you have to be prepared to take on this risk if your business doesn’t work out or goes belly up. This may be a preferred option for you, because you’re not giving away an ownership percentage in the business. If you’re confident that there’s lots of upside and you don’t mind taking on the debt, then this may be the right option for you.
Equity, on the other hand, does not have to be paid back over a fixed term but provides for an actual ownership stake in the business. For example, using the Uncle Buck example, you need $10,000 to start your business. You agree to give Uncle Buck 10% of the equity in the business for that $10,000. As the business grows and generates profit – or is even sold – Uncle Buck is entitled to 10% of the proceeds. The hope is that the business will do well and Uncle Buck will see more than his $10,000 investment returned!
Conversely, if the business fails, and there is no profit, Uncle Buck may lose his entire $10,000 investment. Unlike a loan, which you have to repay, with equity funding Uncle Buck is taking on part of the risk – in exchange for the possibility of greater profit if the company is successful.
Selling an equity percentage may be an attractive option for you instead of debt, since you don’t have to make monthly payments, pay interest, or sign a personal guaranty. From that perspective, it’s a little more flexible. However, with an equity investor, you’re giving up some percentage of ownership in the business. If your business is financially successful, then you’re sharing that with an investor or multiple investors. These investors may also have a say in how your business is being run. You decide what’s right for you.