Debt or equity? Ten questions for funding a small business, and how to grow with less capital

Sooner or later, almost every business needs money it does not yet have: to start, to buy equipment, to fund a large order, to open a new location or to enter a new market. The question “how do I raise funds?” quickly becomes a more important one: which kind of money suits this business, at this stage, for this purpose?

Broadly, external funding comes in two forms. Debt means borrowing money that must be repaid with interest. Equity means selling part of the ownership of the business to investors who share in its future success or failure. Each has very different costs, risks and consequences. Choosing the wrong one can strangle a promising business with repayments it cannot meet, or give away a large share of a business that could have funded itself.

This article sets out ten questions that help decide between debt and equity, describes the main sources of each in Australia, explains why customers are often the best investors of all, and offers practical ways to grow with less capital.

The two families of funding

Debt

Debt is a loan: the lender provides money, and the business repays it, with interest, over an agreed period. Common sources for Australian small businesses include:

• Banks: term loans, overdrafts and lines of credit, often secured against property or business assets.
• Non-bank lenders: specialist lenders that may approve faster or lend where banks will not, usually at higher interest rates.
• Equipment and asset finance: loans or leases secured against the equipment being purchased, such as machinery, vehicles or computers.
• Invoice or debtor finance: borrowing against unpaid customer invoices to bridge the gap between delivering work and being paid.
• Trade credit: supplier payment terms, which are a form of short-term, often interest-free funding.
• Business credit cards: convenient but expensive, best kept for short-term purchases paid off in full.

Equity

Equity means bringing in owners. Sources include:

• The founders’ own savings, often the first equity in any business.
• Friends and family, who invest because they trust the founder.
• Angel investors: individuals, often experienced business people, who invest their own money in early-stage businesses.
• Venture capital funds, which invest larger sums in businesses with potential for very rapid growth.
• Crowd-sourced equity funding, in which many investors buy small stakes through platforms licensed by ASIC.
• Private equity, usually for established, profitable businesses.
• Public share offers, through listing on a stock exchange, rare for small businesses.

Other sources worth knowing

• Government grants and programs, listed on business.gov.au, which change frequently. Many have strict eligibility rules and require matching funds.
• Tax incentives, such as the Research and Development Tax Incentive for eligible R&D activities, which provide benefits after the money is spent rather than before.
• Customers, through deposits, pre-orders, progress payments and subscriptions, discussed below.

Ten questions for choosing between debt and equity

1. How predictable is your cash flow?

If your business earns steady monthly revenue, such as recurring contracts, regular customers or a predictable sales pattern, you can plan loan repayments with confidence. If cash flow is uncertain or delayed, for example a new product that will take two years to sell, or a business that may grow suddenly after a long build-up, fixed repayments become dangerous. Predictable cash flow favours debt. Uncertain or delayed cash flow favours equity.

2. How profitable is the business?

High margins generate the cash to meet interest and repayments comfortably. Thin margins leave little room when sales dip or costs rise. Equity shares risk: if profits are delayed, investors wait with you rather than demanding repayments. High margins favour debt. Low margins favour equity.

3. What does the money cost?

Debt has an explicit cost: interest. Equity has a hidden but usually larger cost: a permanent share of future profits and growth. Investors take more risk than lenders, so they expect higher returns, often far higher than any interest rate. Debt is usually cheaper. Equity is usually more expensive, if the business succeeds.

4. What security can you offer?

Lenders want to be repaid even if the business struggles, so they usually ask for security: property, equipment, receivables, or personal guarantees from directors. They typically lend only a proportion of an asset’s value. Without security, bank borrowing is difficult. Equity investors, by contrast, invest on the strength of your plan, team and potential, without security. Available security favours debt. A strong plan without assets may need equity.

5. Who carries the risk?

A secured lender can recover money by selling the security if the business fails, so their risk is lower. An equity investor has no security. If the business fails, they lose along with you. Because they carry more risk, they expect a greater reward. The party carrying more risk expects more return.

6. Are you willing to share ownership and control?

Lenders do not own any part of your business. Once you repay the loan, the relationship ends. Equity investors become part-owners. They may want board seats, regular reporting, a say in major decisions and rights in future funding rounds or a sale. If keeping full ownership and control matters to you, favour debt.

7. What returns does the funder expect?

A lender’s return is fixed: the agreed interest rate. An equity investor’s return is variable: potentially very high if the business grows, or nothing if it fails. Investors back businesses that could multiply in value, not ones that will merely survive.

8. Who shares the upside?

With debt, all growth beyond the loan’s cost belongs to the owners. With equity, investors share every dollar of growth, forever, in proportion to their shareholding, unless you buy them out. If you expect strong growth that debt could fund, debt keeps the upside for you.

9. Will the funding help or hinder growth?

Loan repayments start immediately and consume cash that could otherwise fund growth. Equity carries no repayment obligation, so the business can invest the full amount for several years. As the business grows and its value rises, later investors may come in and early investors may sell their stake. For businesses that need years of investment before earning, equity provides breathing room.

10. How much can you actually raise?

Lenders assess serviceability: whether the business generates enough cash to meet repayments with a margin of safety. Many lenders look for operating cash flow comfortably above total loan repayments, though criteria vary. Once a business reaches its borrowing capacity, further loans become unavailable. Equity can be raised repeatedly if the growth story is credible, and a larger equity base often makes lenders more willing to lend. Debt is limited by current earnings. Equity is limited by future potential.

A summary table

Many businesses end up using both, at different stages and for different purposes. A useful principle is to match the funding to the asset: long-term assets such as machinery and premises suit long-term loans, short-term needs such as working capital suit short-term facilities, and risky, uncertain ventures suit equity.

Customers: the best investors

Before borrowing or selling shares, ask whether your customers could fund your growth. Customer money is the cheapest funding there is: it costs no interest, requires no equity and proves that people want what you sell. Ways to raise it:

• Deposits on custom orders, common in manufacturing, construction and furniture.
• Progress payments on long projects, tied to milestones.
• Pre-orders for new products before production starts.
• Subscriptions and annual contracts paid in advance.
• Shorter payment terms for customers, balanced with longer terms from suppliers.

Investors also notice. A business that can show customers paying in advance is far more attractive than one asking investors to fund an untested idea. The article on chasing customers, not investors explains this in more depth.

Remember that customer deposits must be handled carefully: they are owed back if you cannot deliver, and spending them on unrelated costs can create serious problems.

Growing with less capital

Some businesses grow substantially without loans or outside investment. An innovative robotics start-up in India, recognised internationally for its work, built humanoid robots with fewer than thirty staff and no external funding. Its leaders describe five principles that apply to many small businesses.

1. Build a “maker” team

Hire people who solve problems themselves rather than waiting for outside experts. Multi-skilled makers cost less than a large team of specialists and checkers. Test candidates with real tasks during interviews, and keep good people by giving them work that interests them.

2. Let deadlines come from customers

Internal deadlines are easy to move. Deadlines tied to a customer delivery, a trade show or a launch create shared urgency and energy. That start-up once had three weeks to prepare robots for a major international summit, and the fixed public deadline mobilised the whole team. Be transparent with the team about commitments to customers.

3. Diversify your sources of income

When core product sales are slow, look for related income: demonstrations, consulting, training, maintenance, rentals or smaller products built from the same capability. Reinvest that income in development.

4. Practise frugal engineering

Avoid large loans or investments early. Do as much as possible in-house, outsource only what you cannot do well, and design products and processes to use materials, machines and time efficiently. Buy second-hand or refurbished equipment where reliability allows.

5. Make technology your advantage

A distinctive technology that solves a pressing customer problem, offered at a competitive cost with good service, creates an advantage that is hard to copy. Where appropriate, protect it through patents, registered designs, trade secrets and confidentiality agreements. IP Australia explains the options.

A worked example

A small precision engineering business earns steady revenue from long-term contracts with three industrial customers, with monthly operating cash flow of about $25,000 after the owners’ salaries. It wants a $300,000 CNC machine to take on a new contract.

Option A: equipment finance. An illustrative loan of $300,000 at 9 per cent over five years costs about $6,230 a month, or about $373,650 in total. Monthly cash flow comfortably covers the repayments, and the machine itself is security.

Option B: equity. An investor offers $300,000 for 25 per cent of the business. There are no repayments. But if the new contract lifts annual profit to $400,000, the investor’s share is $100,000 a year, every year, for as long as they hold their shares.

Because cash flow is predictable, margins are healthy and the machine provides security, debt is clearly the better choice here. The interest cost of about $73,650 over five years is small compared with permanently giving away a quarter of the business.

Now consider a different business: a two-person start-up developing a new medical device that needs two years of development and regulatory work before any sales. It has no assets and no revenue, and its future is uncertain. Fixed repayments would be impossible. Equity from angel investors, combined with grants and the R&D Tax Incentive where eligible, suits it far better.

Common mistakes

• Raising equity too early, when the business has not yet proved anything, so founders give away large stakes for small sums.
• Borrowing to cover operating losses rather than to fund productive investment. This usually postpones problems and makes them bigger.
• Mismatching terms, such as funding a long-term machine purchase with a short-term overdraft.
• Underestimating working capital. Growth ties up cash in stock and unpaid invoices. The article on reading the balance sheet, cash and working capital explains why.
• Signing personal guarantees without understanding them. A guarantee can put your home at risk if the business fails.
• Giving early helpers equity without vesting, so people who leave early keep their full stake.
• Ignoring the shareholders’ agreement. It governs decisions, exits and disputes, so it deserves as much attention as the price.

Frequently asked questions

Should I use my home as security? Many small business loans are secured against owners’ homes. It can unlock cheaper finance, but it means business failure could cost you your home. Get independent legal and financial advice, and borrow only what the business can clearly service.

How much of my business should I sell to investors? It depends on the amount, the stage and the valuation, but founders should keep enough ownership to remain motivated through future funding rounds. Understand how each round dilutes existing shareholders.

Are government grants worth pursuing? Sometimes, especially for research, export and specific industry programs. They can be competitive and time-consuming, often require matching funds and usually come with reporting obligations. Do not build a business that depends on them.

What do lenders look at? Typically cash flow, profitability, security, the owners’ track record and credit history, and the purpose of the loan. Prepare up-to-date financial statements, forecasts and a clear explanation of how the money will be used and repaid.

Summary

Debt and equity suit different situations. Use ten questions to choose: cash-flow predictability, profitability, cost, security, investor risk, ownership, returns, upside, growth breathing room and capacity. Predictable, profitable businesses with security usually benefit from debt, while uncertain, early-stage or high-growth ventures usually need equity. Match funding to the asset, ask customers to fund growth where you can, and grow frugally with a maker team, customer-driven deadlines, diversified income and a technology advantage. Get professional advice before committing to significant borrowing or selling equity.

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Sources: small-business training notes on raising funds through debt and equity and on expanding with less investment, together with general Australian small-business finance practice. Examples and figures are illustrations. This article is general information, not financial advice.