Loans and Equity Investments Compared

From the Nolo eCommerce Center
How to choose between getting a loan or selling part of your business to an equity investor.

To raise money for your new business, you must decide whether you prefer to borrow money or sell part of your project to an equity investor. Often, you may not have many options. The person with money to lend or invest will obviously have a lot to say about it. But you should know the trade-offs you normally make by preferring one to the other.

Loans Equity Investments
The lender has no profit participation or management say in your business. Your only obligation is to repay the loan on time. Interest payments (not principal payments) are a deductible business expense. Loans from close relatives can have flexible repayments terms. You may have to make loan repayments when your need for cash is greatest, such as during your business’ start-up or expansion. Also, you may gave to assign a security interest in your property to obtain a loan, thereby placing personal assets at risk. Under most circumstances you can be sued personally for any unpaid balance of the loan, even if it’s unsecured. You can be flexible about repayment requirements. Investors sometimes are partners and often offer valuable advice and assistance. If your business loses money or goes broke, you probably won’t have to repay your investors. Equity investors require a larger share of the profits. Your shareholders and partners have a legal right to be informed about all significant business events and a right to ethical management; they can sue you if they feel their rights are compromised.

Loans are better for businesses if the cash flow allows for realistic repayment schedules and the loans can be obtained without jeopardizing personal assets. Equity investments are often the best way to finance start-up ventures because of the flexible repayments schedules.

If you don’t already know an accountant specializing in small business affairs, you will be wise to find one. Your personal tax situation, the tax situation of the people who may invest, and the tax status of the type of business you plan to open are all likely to influence your choice.

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