While starting a business, should you break an SIP or take loan? Which one should be preferred?

Author
Anmol Gupta

This is really a good question. A business often needs investment and you will face this question whenever you need money for your business.

I’ll give a little broader perspective on this treating your SIP as your own wealth. Your own wealth can be in any form be it SIP (Mutual Funds), Stocks, Cash, Bank deposits etc.

So, depending on type of business you are doing and stage of your business, the way to finance can differ.

Case 1: You are starting a ‘startup’

In this case, your are doing something innovative and you are not sure how its gonna work out. You don’t have well defined or well running revenue channels, and profits are nowhere to be seen. For first few months or even years, you are going to find your product market fit and burn money in experiments.

In this stage, having a burden of monthly repayments to bank loan or any kind of loan is not desirable. Also, banks will not give you a loan in this stage as startups are way too risky for banks. Hence, you should raise money at this stage through equity route i.e. investing your own money and take shares of the company and/or issue shares to other people who are willing to risk their money with your startup - people like Angel Investors and Venture Capitalists. Raising money from them is altogether a different game but technically this is the correct route at this stage. This will give you peace of mind as you don’t have obligation to make monthly repayments to anyone. If your startup does well, everyone gains. If it fails, every equity investor loses the money.

Case 2: You have graduated from startup to a business or you are already starting or running a ‘business’

In this case, you have well defined revenue channels and most likely you are also profitable. You business is stable. You have also determined that if you put x amount in your business, that x will generate much more profit than x. Money is needed only to fuel growth at this stage and not to do experiments. Here you have both the options - equity and debt (loan). Let’s evaluate both the options assuming if you raise x amount, you can turn it into 1.4x.

Equity: Equity investors like angel investors and VCs would want at least 1.3x return on their investment in one year i.e. if they put x amount in your business, they want 1.3x in return. So, if you take x from them and make 1.4x with that money, you will repay 1.3x to such investors and effectively the company will make 1.4x - 1.3x = 0.1x. But, if for some reason you happen to lose all the money, you won’t have to pay anything to equity investors. Equity investors want more return for the risk they take. They don’t put you under any obligation for regular repayments, but want greater return.

Debt: Debt investors like bank loan will typically ask for 1.1x to 1.2x return on their investment. Let’s say 1.15x. So, if you make 1.4x on x taken from bank, you effectively gain 1.4x - 1.15x = 0.25x. Your business is making more money in case of debt financing. But, if you lose all the money you raised, you still are liable to pay 1.15x to bank. But, if you know for a fact that chances of you not losing the money are negligible, debt is better option as your business will make more money effectively.

Cost of Debt < Cost of Equity

This is a very common concept in Corporate Finance - deciding to finance your business through equity or debt. Since cost of debt (the return which debt investors want) is usually lower than the cost of equity (the return which equity investors want), debt is preferred option for financing a business theoretically. Theoretically, a business should run on 99.99% debt :) [Can not be 100% as business needs shareholders]

Then, why don’t businesses raise all the money through debt?

Because

1) Debt is not accessible to everyone (like case 1 businesses)

2) A business always has some risks. Raising all the money through debt puts pressure even on established businesses. What if the business doesn’t do as per expectations for a few months and doesn’t have cash to pay the bank? That’s why business also do not go for 100% loans or debt.

Originally answered on Quora.


About the Author
Anmol Gupta
Anmol is CEO at 7Prosper. He is SEBI Registered Investment Adviser, with expertise in Finance and Technology domains. Anmol is committed to help people achieve their financial freedom.

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