There are generally two ways to finance your business – debt and equity. Debt financing is when you borrow from the bank, while equity involves issuing or selling your shares to other investors.

If you are a new business owner, you should be completely clear on the risks of using debt or equity, as each option has its pros and cons. Success or failure of your venture could hinge on which form of financing you employ.

Debt risks

1. Mandatory interest payments

A bank loan requires you to make monthly repayments with interest, which could pose a risk to your cash flow.

Typically, it will take some time before your business is able to generate revenue. This means you will be tight on cash while needing to service the loan, on top of maintaining expenses such as salaries, rent, licences and other costs.

Always be sure your business venture can sustain itself while waiting for revenue to roll in.

2. Losing collateral

The bank will require collateral from you as an insurance in case you fail to repay the loan. The more your assets are worth, the bigger a loan you qualify for, allowing you to potentially generate more profit.

However, higher returns equate to higher risk. While banks do not simply take possession of your collateral unless they have to, losing your assets could disrupt your personal and family life, and significantly reduce your standard of living.

3. Bad credit rating

It is important to maintain a good credit rating as banks evaluate your credit profile whenever you apply for a loan. A bad credit rating is flagged as risky, leading banks to increase the interest rate and repayment amounts.

Your business could fail if the interest rate is too high or you can’t get enough of a loan amount. You might have to undertake simultaneous new ventures or investments to cover your loan repayments.

Also, a bad credit rating tends to have long-term effects. Your business might grow increasingly profitable, but banks would nevertheless take into account your past credit rating in their future dealings with you.

Equity risks

1. Losing ownership and control

When you issue or sell shares to external investors, you can raise funds for your business without putting up collateral and having to pay interest.

However, you could lose control and ownership if you rely too much on equity financing. More investors means more viewpoints and opinions. Decisions will be harder to pass and approve, and the vision of the company might change.

You could even be removed from the organisation if the other investors band together to buy your shares out.

2. Lower yields for yourself

When the company is profitable, you can reap the benefits by issuing dividends to yourself and other investors. But as your ownership of the company decreases, so does your share of profits.

This can be burdensome if the company generates a record amount of revenue with you as the primary driver of projects and ventures. That said, you should balance this with the simple fact that you needed funds from the other investors to begin with.

3. More requirements

An investor who is interested in your company would want to know in detail what your organisation is about, your vision, and its future prospects.

Hence, regulators require firms to properly disclose information to ensure potential investors are well informed.

For this, you would need to obtain the services of consultants, legal teams, and other finance professionals. You would also need to tidy up your financial accounts so you are prepared in the event of an audit.

This article first appeared in MyPF. Follow MyPF to simplify and grow your personal finances on Facebook and Instagram.