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At some point, every small business owner or entrepreneur needs financing to help their company grow. And when this day arrives, there are two main sources of financing: private equity investments and small business loans. In this article, weâll look at the difference between the two, and try to answer the question of which type of financing is better for small businesses.
What are private equity Investments?
Private equity investments offer entrepreneurs and small business owners a way to fund their business needs. A private equity investor can be any individual or organization that funds a private or public business in exchange for an ownership share of the company, including private equity funds, friends and family, angel investors, or venture capitalists. The arrangement benefits the business because they get access to the funding they need, and the investor gains the opportunity to earn more through profits than they initially invested. Just like any other source of business funding, there are pros and cons to private equity investments.
What is a private equity fund?
Forbes published an article this year that addressed the increasing popularity of private equity as a source of business financing. The article stated that âprivate equity deal value reached a record-setting $787 billion in 2021.â In this context, private equity (PE) can be defined as a type of business financing where private or public companies accept money or assets from a private equity fund. The term often is used to refer to a group of investment funds that invest in or purchase small businesses that are privately owned.
Securing funds through a PE fund is not a viable option for all small businesses. Private equity firms typically select their investments based on certain strategic criteria. The criteria may narrow down eligible businesses based on how long theyâve been operating, whether they are maximizing profitability, or even geographical regions. Private equity funds take a significant, sometimes majority, ownership stake in the business where the investors participate in making business decisions about daily operations.
What are Angel Investors?
Angel investors are private investors that provide funding to small businesses in exchange for ownership equity, like private equity firms. However, the difference is that angel investors are individuals, not part of a larger firm. Historically, angel investors have been known to be people with a high net worth that look for startup businesses and small private companies that have the potential for significant growth. Angel investors are not required to be certified in any way and they are often found in the small business ownerâs community of friends and family. Accepting funds from an angel investor may be a one-time arrangement or an ongoing agreement with defined time or maximum fund parameters.
Startup entrepreneurs and small business owners in their first two years of operations often prefer to work with angel investors over private equity firms because eligibility requirements and financing qualifications may be fewer. Angel investors choose which businesses to give money to based on relationships, personal preference, or which business plans pique their interest. If a new business idea, funded by an angel investor, takes off, then the angel investor stands to make a profit.
Since angel investors are trading cash for ownership shares, you wonât have to repay their investment with interest like you would a loan. Angel investors make their money when your company is successful, so their stock in your firm rises and they are able to sell their stake at a profit. Angel investors may or may not participate in decision-making, management, and operations.
Since most often angel investors are successful people with experience in the business world, one of the perks of this type of finance is that they are often available to provide input and guidance.
What are Venture Capitalists?
Venture capitalists are equity investors, like angel investors, that act as financial contributors to growing businesses in exchange for equity in the company. These types of investors may work alone and invest personal funds into the business, or more commonly, they are part of a venture capital firm. Venture capital firms are made up of a group of investors that combine their finances into an investment pool intended to finance other businesses. Venture capital firms are typically known for making several large investments at the same time.
While venture capitalists work like angel investors, in that they give money to a business in exchange for a piece of future profits, there are some differences. Venture capitalists typically seek out businesses that have been operating for more than one year and show great potential to become lucrative. The initial investment made by a venture capitalist is typically more than $500,000 so the amount of equity they seek is higher. Since these types of investors typically operate as corporate entities, the selection process is more formal than with angel investors. Venture capital firms may seek to invest in certain industries, like social media, technology, or finance, and may not be open to startup entrepreneurs.
What are small business loans?
Small business loans are a type of financing where the small business owner borrows capital from a traditional lender, like a bank or credit union, or an alternative lender, like an online lending marketplace, and repays the loan according to a formal loan agreement. There are many different types of loan products intended as business financing, each with its own eligibility requirements, maximum loan amounts, and loan terms.
A term loan is a type of loan program where approved borrowers receive a lump sum payment upfront and then make monthly payments of interest and principal to the issuing financial institution. Term loans can be secured, where some form of collateral, usually business assets, is held by the lender, or unsecured. This loan type appeals to small business owners because it offers access to the full loan amount upfront and can be repaid early, sometimes with little or no prepayment penalty. Small businesses may be eligible for either long-term or short-term loans when choosing a term loan.
Business lines of credit
A business line of credit is revolving credit, like a business credit card, where the lender approves a maximum amount of credit. The borrower can then withdraw funds quickly whenever they experience cash flow shortages. Interest is paid only on the amount of funds that have been withdrawn, so payments remain reasonable. Having a line of credit is a smart financial decision because it allows small business owners to have instant access to capital.
SBA loans are a type of business financing where the funds are partially guaranteed by the U.S. Small Business Administration. SBA loan programs, like the SBA 7(a) loan, disaster loans, or microloans, can be used to increase working capital, make large purchases, refinance high-interest debt, and more. Borrowers often choose SBA loans if they can meet the strict approval requirements and lengthy application process because they offer low down payments, lower interest rates, and long repayment terms.
Which is the better business financing option?
Deciding on the best source of business financing is not as simple as ranking funding opportunities. The type of financing that is best for your small business will be the source of necessary capital that allows you to meet business needs, achieve your goals, and not negatively impact the businessâs future. When researching business lending and investing opportunities, consider the following advantages and disadvantages of each type of financing.
Advantages of securing capital through private equity
Whether you secure funding from an angel investor, venture capitalist, or private equity firm, there are pros and cons to this type of financing.
- Since there is no formal application process for investors, finding funds through friends and family, a PE or venture capital firm, or crowdfunding, can give small business owners fast access to capital.
- There is no repayment of investment funds expected if the business fails to become profitable, so there is little risk to entrepreneurs.
- Accepting equity financing from an investor means that there is potential for additional funds because investors often act as financial partners willing to do whatever it takes to enable success.
- Investors come with industry knowledge and the motivation to see a return on their investment so they can provide expert business guidance to entrepreneurs in the early stages of business.
Advantages of using a small business loan for funding
Working with a traditional lender or an alternative lender, like Biz2Credit, to secure a small business loan can benefit an entrepreneur in the following ways:
- Lenders report payment activity to credit bureaus, so taking out a business loan or line of credit is a great way to build better business credit.
- When a lender issues business funds, there are clear repayment terms listed in the loan agreement so borrowers know exactly how much money they will repay.
- While lenders may review business plans during the approval process, they do not participate in day-to-day business operations, as they do not hold an ownership stake.
- Business loans can be paid off at any time, although some loans include a prepayment penalty, so if profits exceed expectations the financial obligation can end.
Disadvantages of securing capital through private equity
Working with a venture capitalist or other type of investor also has some disadvantages including:
- There is no limit on the return the investor can collect since they have purchased equity in your company and will receive a set percentage of profits forever.
- Investors are hard to find, especially for startup entrepreneurs and new businesses, since they are typically looking for a very specific type of company to invest in.
- Accepting financing from an investor means you will have to give up control over some or all of the business decisions.
Disadvantages of using a small business loan for funding
Small business loans are the most common type of business financing, but that does not mean there arenât disadvantages to taking out a loan.
- Lenders have eligibility requirements, that may include annual revenues, time in business, and business credit history.
- Lenders may require collateral or a personal guarantee to secure a small business loan.
- Borrowing money from a business lender may include restrictions on the use of the funds, like in the case of SBA loans or equipment financing.
Finding the right business financing can be the key to starting and running a profitable business. To secure the capital needed to achieve your business goals, consider the advantages and disadvantages of private equity investments versus small business loans. While private investors offer money that doesnât need to be repaid, they will have an ownership stake in your firm, which may mean giving up some decision-making power for you. Small business loans are the more common source of financing, in part because of the diversity and availability of unique loan products, like term loans and SBA loans.
If your small business needs funding, reach out to Biz2Credit to learn about the best financing options for your business needs. Ray Vasquez, owner of Johnny Rockets Sports Lounge was able to secure the startup capital he needed to turn his business dream into a reality by working with Biz2Creditâs expert financing team.