Most likely, bank loans or loans from an alternative lender are among the first options that come to mind. However, an increasing number of business owners are opting for private funds from accredited investors. However, before you start pursuing specific loan products or potential investors, you should 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. Still, 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 business financing options and how they might affect your business's long term goals, we’re going to break it all down in this post.
The Pros and Cons of Private Investors
The Pros of Private Investors
- Less Complicated Application Process: Typically, finding investors for a small business is beneficial because they don’t necessarily require the same type of verifiable financial health that a bank would.
- No Collateral Required: Private investors don’t require collateral and are far more likely to give you money simply if they believe in you and your idea. Similar to crowdfunding platforms, investors seek out business ideas that they're passionate about.
- Can Be an Affordable Funding Option: 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. In addition, if you find family or friends to invest in your business, you can devise an even more flexible plan.
- Less Risk of Legal Issues: Perhaps most importantly, private investors generally can’t take you to court as easily as a bank can for not paying them back.
The Cons of Private Investors
- Difficult to Negotiate Terms: 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.
- Loss of Business Control: Investors can ask for (and often get) a large equity share in your business. In this way, you give up control over your business decisions, which can lead to problems in the future.
- Drawing Up Legal Contracts Is Time Consuming: There are quite a few legal considerations about raising money through a private placement. For instance, 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.
The Pros and Cons of Business Loans
The Pros of Business Loans
- More Control Over Your Business: Since they’re fairly standardized, small business loans aren’t nearly as varied as private investments. 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. However, with a small business loan, as long as you make your payments on-time, that won’t be the case.
- You Keep the Profits Of Your Business Investment: With a business loan, you don’t give up any of the upside in your small business. If you use a $500,000 term loan and turn it into $1.5M in profit, that profit is all yours.
- Application Process is Straightforward: When compared to raising private investment, obtaining a business loan is more straightforward in terms of paperwork and liability issues.
The Cons of Business Loans
- Can Be Challenging to Obtain Large Loan Amounts: Particularly for early-stage small 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.
- May Require Collateral: 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: Investors vs. Business Loans: Determine What’s Right for Your BusinessRegardless 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 small business's needs, you’ll find the right path forward.
Editor’s Note: This post was updated for accuracy and comprehensiveness in May 2021.