Business Loans vs. Private Investors: What's Right for Your Business?
Before you start pursuing specific loan products or potential investors, though, you’ll have to determine if applying for a loan or searching for a private investor is right for your company.
In the simplest terms, this decision comes down to risk versus return. However, with private investments and business loans, there are so many factors that affect risk and return that a careful evaluation is mandatory for you to make an informed decision.
To help you understand the pros and cons of both options and how they might affect your business, we’re going to break it all down in this post.
Pros and Cons of Private Investors
Pros: For new business owners, private investors are attractive because they don’t necessarily require the same type of verifiable financial health that a bank would. In addition, private investors don’t require collateral and are far more likely to give you money simply if they believe in you and your idea.
Moreover, in the short-term, raising money through private investors may be far more affordable than taking out a loan. The deal with your investor can be structured so that the investor only starts getting a share of your profits once you’re profitable. Perhaps most importantly, private investors generally can’t take you to court as easily as a bank can for not paying them back.
Cons: Many of the benefits of private investors can be turned on their head. For example, because private investors don’t require collateral or verifiable financial history, you’re in a weak bargaining position. They can ask for (and often get) a large equity share in your business. In this way, you give up part of the upside of your business. Additionally, there are quite a few legal considerations about raising money through a private placement. According to the American Bar Association, even if you have friends and family lined up, there are still several legal considerations to make before you raise money through private investors. You’ll need a lawyer to help you draw up documents and advise you on raising money, because if you raise money incorrectly, you’ll be open to serious legal repercussions.
Pros and Cons of Business Loans
Pros: Since they’re fairly standardized, business loans aren’t nearly as varied as private investments. In other words, you know exactly what you’re getting into up front.
For example, with a private investor, you’re inviting someone into your business who might cause problems later. They might drain your time by constantly asking for updates or sticking their hands in your business. With a loan, as long as you make your payments, that won’t be the case.
In addition, you don’t give up any of the upside in your business. If you use a $500,000 loan and turn it into $1.5M in profit, that profit is all yours. Also, compared to raising private investment, obtaining a business loan is more straightforward in terms of paperwork and liability issues.
Cons: Particularly for early-stage business owners, large business loans are difficult to obtain. The ones that are available to you in the early stages of your business usually have less favorable terms, like higher interest rates or smaller amounts.
Loans also tend to carry more downside risk than private investment. With a business loan, you could have to put up collateral, which the bank can take if you fail to pay. Also, if you’re required to sign a personal guarantee on your business loan, they can come after your personal assets.
Conclusion: Determine What’s Right for Your Business
Regardless of the route you take, you’re essentially paying in the long run for short-term cash; so, the decision boils down to how you want to make that payment.
Raise money through private investors, and your “payment” is less control of your business and a smaller share in your company’s growth. Take out a business loan, and your payment could come in the form of interest, fees, and the risk of default.
The reason this is a unique decision for every business is that we’re talking about several things whose value changes based on your circumstances. Perhaps giving up a share of your business isn’t an issue for you, or maybe you believe your risk of default is extremely low. In either case, part of the “cost” of private investments and loans depends on your individual context.
All that said, just because it’s a complicated decision doesn’t mean it must be a difficult one. When you break each option down and weigh them based on your business needs, you’ll find the right path forward.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.