The state of small businesses has not gone unnoticed in the 2020 presidential race that has begun to heat up in earnest. Elizabeth Warren, a senator from Massachusetts and contender for the Democratic nomination, rolled out a plan in June 2019 that would establish a $7 billion equity fund to help minority entrepreneurs.
Setting aside the political debate, Sen. Warren’s proposal might prompt the average voter to ask what exactly an equity fund is and if this is a loan program for small businesses.
The answer is… sort of, but not really.
The proposed Small Business Equity Fund underscores a key question startup businesses must ask themselves:
Do they prefer equity or debt financing?
What is debt financing?
Debt financing is when the entrepreneur gets a loan to start their business, pays the money back with interest, and once that’s completed, all relationship with the lender ends.
But there are significant drawbacks with the debt financing model.
The most obvious, and the one addressed by Warren’s plan, is that debt financing leaves new businesses saddled with monthly payments at a time of vulnerability, which slows expansion and hiring.
What is equity financing?
Equity financing, on the other hand, doesn’t require repayment by the borrower, thus freeing up money to grow the business. But that doesn’t mean there are no strings attached. Equity financing comes with its own set of drawbacks.
Instead of repayment, the lender is given a share of the business and all that entails—including the right to share profits, the right to be consulted on any new initiatives and potentially the right to withhold approval of any expansion.
The Warren Plan would create a Department of Economic Development Grants to establish federal guidelines for equity funding. How the consultative and profit-sharing roles would play out remains to be seen.
It sets up an interesting discussion. Most entrepreneurs don’t have a choice on whether to take debt or equity financing. Circumstances usually dictate their decision.
That won’t be the case for voters in the Democratic primary and potentially the general election.