Oct 28, 2022 | Starting a Business

Is it better to get an investor or a business loan from a bank?

Q. Dear Zenagos, What are the pros and cons of getting an investor vs getting a loan (from a bank or from an individual)?
–Marion

If you are in a position to choose between taking out a loan and bringing in an investor, that is good news. Both loans and investors can be difficult to acquire. Ironically, it is easiest to get money for your business when you don’t need it. If you do need money, investors and lenders both provide funds for your business, and those funds come with strings (or conditions) attached. You will decide which is better for your business based on which conditions are easier for you to tolerate.

Pros and Cons of Investors

Investor Pro: Investors take most of the financial risk
An investor gives you money in exchange for a formal interest in the company. That interest is usually in the form of company stock (also known as “equity”). You may find our earlier posts about how investment works and the types of investors relevant and informative. The biggest pro of taking on an investor is that the investor takes most of the risk: If the company fails, you do not need to repay the money.

Investor Pro: You can start a company with no money and/or bad credit
Equity is also relatively inexpensive and easy to acquire: You can start a company even if you have no money and bad credit, as long as you have investors who are willing to fund the company’s formation and operations.

Investor Pro: Some investors improve your probability of success
The easiest type of investor to manage is the “silent partner,” who gives you the money and stays out of the day-to-day operations and decision-making of the company. It can be even better to have an experienced and networked investor who helps you by providing leads to potential customers, connections to other investors, and advice on how to handle tricky business transactions. This type of investor provides more than money and actually increases the probability that your venture will succeed (Kerr, Lerner, & Schoar, 2014; Hudson, 2015).

Investor Con: The investor takes more of the financial rewards
Because the investor takes most of the financial risk, the investor also receives more of the financial rewards. Some entrepreneurs have a hard time understanding why their investors receive such a high percentage of the company’s earnings, when the entrepreneurs brought all of the expertise and did all of the hard work. If you will have a hard time watching the investor reap the rewards of your effort, then you need to find a way to finance the company yourself. Most entrepreneurs accept that the investors will get most of the benefit from the first company, but then the entrepreneur intends to self-fund their second company.

Investor Con: You could lose control of the company
If the investor receives more than 50% of the company’s stock in exchange for the investment, then the investor acquires “control” of the company and effectively becomes your boss, controlling the company’s decisions. The investor can also take control if the bylaws of the company provide the investor with a controlling number of votes, or if the investor creates an alliance with other investors to collaboratively control the company. So, one of the major cons of taking on an investor is that it creates the potential for you to lose control of your company.

Investor Con: Investors can interfere in company decisions
Even if you have constructed the company and its bylaws such that your investors cannot take formal control of the company, most investors will demand to be informed about company operations and will make “suggestions” that you will feel pressure to follow. They may tell you who to hire or fire, and they may demand that you take on specific customers. Even if you do not follow these “suggestions,” you will need to engage with the investors and manage their input, which can be time-consuming and tiring.

Pros and Cons of Loans

Loan Pro: You keep the rewards
When you take a loan, you typically repay the loan with interest. This arrangement is called “debt” (as opposed to the investor arrangement, which is about “equity”). Because you commit to paying interest and to meeting specific rules (or “covenants”) for the loan, you take most of the risk. As a result (assuming you meet the terms of the loan), you get to keep the earnings of the company. When you pay off the loan, you have no further obligation. In contrast, when you take on an investor, you give away a percentage of your profit for the rest of the company’s future.

Loan Pro: You keep control of the company
As long as you meet the terms of the loan, you retain control of the company. Watch out for loan terms that can cause debt to transition into equity under certain conditions (“warrants”). Some lenders will use instruments like these to take your company if you fail to pay them back.

Loan Con: Loans are difficult to acquire
Lenders typically have strict rules for giving out loans. A company must usually show two years’ audited financials in order to qualify for a loan. There are exceptions, such as SBA Microloans, which are designed for startups, but these loans will typically require the entrepreneur to provide collateral or some other form of personal guarantee for the loan. So, unless you are already in a good financial position, loans can be difficult to acquire.

Loan Con: Banks may place restrictions on your company until the loan is paid
In order to protect their interests, lenders attach specific rules (or “covenants”) to their loans. These are restrictions on how the company manages its money that are designed to provide red flags if the company starts to struggle financially. In addition to the requirement that you pay back the principal and interest on a specific schedule, you may be required to keep a certain ratio of debt to equity or to have a certain amount of cash on hand at all times. Or, you may be required to take on new types of insurance.

Life is full of trade-offs
When your company is doing well, investors and lenders are wonderful partners who can help you to expand your business and improve your probability of success. However, when you accept money from someone else, there are always conditions. If your company has a lot of equipment and other physical assets that can serve as collateral, then bank loans can work very well. If your company needs to grow quickly without a lot of assets, then an investor can be a lifesaver. Ultimately, the choice will come down to your comfort level with the trade-offs and your trust in the people involved.

References

Hudson, M. (2015, May 27). Studies find angels significantly impact success of funded companies. Forbes. Retrieved on October 27, 2022, from https://www.forbes.com/sites/mariannehudson/2015/05/27/studies-find-angels-significantly-impact-success-of-funded-companies/?sh=20b370c2ca84

Kerr, W. R., Lerner, J. & Schoar, A. (2014). The consequences of entrepreneurial finance: Evidence from angel financings. Review of Financial Studies 27(1). 20–55. Retrieved on October 27, 2022, from https://www.hbs.edu/ris/Publication%20Files/Kerr_Lerner_Schoar%20RFS14_03db8dad-0d3e-4478-9b98-ca5bac8f803b.pdf

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