Equity, Banks, and Business Loans: A Quick Guide

Introduction

Bank loans are a common way for small and growing businesses to finance operations, equipment, or expansion. Understanding how equity fits into the picture helps owners compare debt financing (loans) with equity financing (selling ownership) and make informed decisions with lenders.

What is equity?

Equity in a company

Equity refers to ownership in a business. It can come from invested capital, retained earnings, or ownership shares held by founders, partners, or investors. In general, higher equity means more ownership and a larger cushion for the business financially.

Equity as a cushion against risk

From a lender’s perspective, equity signals that owners have skin in the game and has the potential to absorb losses if the business underperforms. This can influence how a loan request is viewed, but it does not replace the need for solid cash flow and a viable repayment plan.

Debt vs equity financing

Debt financing (loans) provides capital in exchange for repayment with interest, while equity financing involves selling a portion of ownership in the business. Both have costs and implications:

• Debt keeps ownership intact but creates fixed repayment obligations and interest costs.
• Equity dilutes ownership but does not require fixed repayments; investors typically expect a return on their stake.

Businesses choose between or combine both approaches based on growth plans, risk tolerance, and the cost of capital.

Bank loans: how they work

What lenders look for

Banks assess a loan based on the borrower’s ability to repay. Key factors include historical and projected cash flow, profitability, debt service coverage, collateral, and the borrower’s credit history. Personal guarantees or collateral may be required for small businesses.

Common loan features

Loans come with principal, interest, and a repayment term. Terms vary by loan type (e.g., term loans, lines of credit, equipment loans) and lender policies. Lenders also review the business plan, industry outlook, and financial statements.

How equity affects loan decisions

Equity and loan decisions intersect in several ways:

• Owner equity (investment by the founders or owners) can signal commitment and reduce risk in the eyes of lenders.
• Lenders look at cash flow and collateral first. Equity helps only if it strengthens the repayment capacity or provides additional security.
• In some cases, lenders may require an equity injection (owners contributing their own money) as part of the financing package to lower risk, though this is not a universal rule.
• For startups or businesses with limited history, equity financing (such as venture funding) is often used alongside or instead of traditional bank loans.

Overall, more owner equity can improve perceived stability, but solid financials and a clear repayment plan remain the central factors for loan approval and terms.

Key considerations for business owners

• Compare options: debt versus equity financing, and consider how each affects control, cost, and cash flow.
• Build strong financials: clear revenue projections, cash flow statements, and a credible business plan help lenders assess risk.
• Demonstrate repayment capability: a healthy debt service coverage ratio (DSCR) and realistic repayment schedules matter.
• Prepare for collateral or guarantees: understand what assets you can offer and how they are valued.
• Seek professional advice: a financial advisor or lender relationship manager can help tailor financing to your situation.

Conclusion

Equity and bank loans represent different financing paths with distinct implications for ownership, control, and cost. By understanding how equity influences lender perceptions and aligning financials accordingly, business owners can navigate financing options more effectively and choose the path that best fits their growth goals.