Between loan and equity funding, which is best for startups?

• Loan and equity are both viable means of funding businesses
• Some business owners choose either or the bother of them, depending on what works best
• Loan and equity also have peculiar advantages and disadvantages
• Read further to see our financial experts’ insights on this topic

In the early 2000s when Charles chose to resign from his high-salaried bank job to pursue his interest in fashion, he knew for sure that he was doing the right thing. At the time, some of his friends were opting to leave Nigeria altogether for greener pastures elsewhere. He could have done the same thing but chose to stay.

This wasn’t an easy decision by any means because it came with many challenges. As an entrepreneur, Charles had to solve a whole lot of problems all by himself; including funding his business. Although his experience in the financial services sector helped out in this regard, he still had some difficulty deciding on the best funding option for his business.

Funding has long been one of the biggest challenges facing entrepreneurs around the world. It goes beyond merely finding the money, to include knowing the right form of funding to seek. This is very important because oftentimes, the difference between a successful startup and a failed one lies in how the seed-funding is secured.

Loan versus Equity Investment

These are the two main types of credit facilities available to entrepreneurs and startups. When it comes to loans, an entrepreneur can raise debt by borrowing money which must be paid back to the lender (with interest) after a specific duration. Loans can be accessed from the likes of banks, credit unions, finance companies, etc.

Equity funding, on the other hand, basically entails selling a portion of one’s stakes in the business to equity investors who are willing to help you raise much-needed funding.

The pros and cons

Now, both loan and equity have their respective advantages and disadvantages. As mentioned earlier, there really is no one-size-fits-all approach to securing funding. However, bearing in mind the advantages and disadvantages of each funding type and knowing fully well the aims and objectives of a startup will better guide the entrepreneur into choosing what works best for them.

Loan, for instance, can enable the entrepreneur to secure immediate funding without necessarily letting go of full ownership of the business. Therefore, assuming that Charles who was mentioned earlier, had chosen to raise debt to finance his fashion business, he would have been able to, among other things:

• Access funding faster and because loan is faster than equity funding
• Retain ownership and control
• Make all the decisions without external interference
• Forget about his liability forever once his debt is offset
• Interests paid on his loan would be tax-deductible
• Generally, debt financing is cheaper for the very fact that you get to retain full ownership.

[READ: Extramile Africa to drive financial inclusion with N4 million soft loans]

On the flip side, getting a loan to fund your business can also come with some disadvantages. According to Investopedia, “debt financing sometimes comes with restrictions on the company’s activities that may prevent it from taking advantage of opportunities outside the realm of its core business.”

More so, the inability/failure to pay back a loan as at when due is generally bad for anybody’s credit score. It may also attract extra charges.

Meanwhile, equity also has some advantages which can not be ignored. First of all, the entrepreneur is under no obligation to pay back the funding. What this means, therefore, is that he/she will have more money to run the business without thinking about how to pay monthly interests.

However, the very fact that this type of funding requires giving up a percentage of one’s stake in a business is something a lot of entrepreneurs have issues with. Charles, for instance, was very worried that he may eventually lose control of the creative vision he had for his business. This alone informed the final decision he took.

This is a serious concern, particularly so at a point when a business is just starting out. After all, nobody can really understand the vision of a company than the person that founded out. And when he/she has to give up control just to raise funding, it becomes problematic.

[READ: BoI’s disbursements to businesses increased by 130% in FY 2018]

Another disadvantage is that equity funding is not really easy to access. Around the world, equity investors are very choosy when deciding on whether to invest their money in a particular business or the other. In Nigeria, we do not even have a lot of them as much as we have lenders. Therefore, their scarcity in itself is a problem. Perhaps it is all for the best after all.

What the experts are saying

Opinions were, unsurprisingly, split among the experts we interviewed in the course of researching this article. Although financial expert, Kalu Aja, acknowledged that both have advantages and disadvantages, he did add that “Capital Assets Pricing Model says equity is more expensive than debt”.

Once again, imagine giving up a significant portion of your ownership in a business to someone (or a set of people) whose strategic direction may not even align with yours. That’s right, equity funding is expensive!

[READ: Meet Sola Akinlade, co-founder of Nigeria’s foremost payment platform Paystack]

Segun Olarinmoye believes that there is no wrong or right answer when trying to decide which is the best between equity funding and loans.

“There is no right or wrong answer. There are different types of startups and different scenarios, you have to choose what fits that particular scenario. Looking at the big picture if you know what you are doing debt can be cheaper.

“In terms of equity, for example, if you aren’t making any profit for years your shareholders can still be with you. That can happen in debt which requires frequent payment. See a business like Amazon or Jumia they haven’t been making a profit but they ultimately will in the future so if you believe in the dream equity offers you that flexibility to invest.”

On the other hand, a financial expert at Investment One, who chose not to be mentioned, said that equity funding is the best. He gave reasons for his belief;

“Generally speaking, Equity is best. This is because startups usually don’t have the capacity to repay loans at their early stage of existence (particularly early-stage startups); both from the standpoint of cash flow maintenance and the standpoint of revenue generation capacity.

“Equity affords them freedom from the frequent outflows resulting from interest and principal repayments. Also, equity tends to be accompanied by management expertise and social capital (i.e. networking) from the investor.

“There is an argument, however, that loans make startup Founders sit up; in that realising that they have financial obligations make them prudent and motivates them to work hard. But honestly, this isn’t the best way to motivate founders.”

Lastly, Chu Achara, a banker at First Bank of Nigeria, also believes that equity funding is the best for a startup. However, he believes that “as the business grows, a loan may be used because theoretically, loans are cheaper.”

In conclusion, it is the entrepreneur that will eventually have to decide which funding option works best for them. However, it is important to consider the pros and cons before making any such decision. Left for the authour of this article, however, loans would do just fine; especially during the early stages of a business. By the way, Charles eventually made do with a loan, just in case you are wondering.