Debt Vs. Equity Financing

Whether you're an early-stage venture looking to fuel its growth or an established cash business looking for emergency capital, there are numerous ways to acquire capital. Today, the two most popular ones are equity financing and debt financing. Both have their own pros/cons and are preferred under different circumstances. Therefore, it is imperative for business owners and startup founders to be educated enough to make the right decision. Below we speak about the differences between the two and discuss various situations where either method may be preferred.

Equity Financing

Equity financing typically sounds like an appealing to many tech startup founders with companies that may be months/years away from profitability. Equity financing may also suit founders that are profitable but need funding to significantly expand their reach or develop the next phase of their product. The main questions to consider before going down this road are:

  1. Will this capital have a significant impact on growth and development?
  2. How important is it for me to maintain equity and control of my business?
  3. Can I dedicate the time and resources to raising money in this way?

Equity Financing Methods

  • Venture Capital firms: Financial firms that seek out high potential startups to invest large sums of money in exchange for equity
  • Angel investors: Typically individuals with large amounts of money that invest in businesses
  • Family & Friends: Usually small investments made by those close with the founders in exchange for an equity percentage

Pros: In many cases, equity financing provides capital for R&D, employee salaries, and anything else a company would need to be successful. Startups that raise a lot of money also tend to get press, which boosts their reputation as well. Furthermore, equity financing puts all the risk on the investors. If the startup were to fail, company founders would not be liable to pay back their investors the money that was lost. Often, big angel investors and venture firms will even act as mentors and provide access to their vast networks for the startups that they fund.

Cons: While this may sound like a "no brainer" for certain startups, there are a myriad of factors that need to be taken into account. Equity financing tends to be a full-time job for young founders and investors that have large amounts of capital tend to be bombarded by hundreds of companies. Since investors take all the risk in equity financing, they may take a sizable portion of a business for their capital contribution. Not only does this mean less future capital for founders should the company be successful and go public or get acquired, but it also means that an outside party now has a say in the company's decisions with an expensive buyout being the only way out.

Debt Financing

This method tends to be preferred with companies that already have cash flow and have been in business for at least some time. Companies typically choose this route for shorter-term needs. The main questions to deciding whether this is right for your business depends on the following questions:

  1. How fast does my business need capital?
  2. Does my business have the appropriate cash flow to repay the debt?
  3. How important is it for me to maintain equity and control of my business?

Debt Financing Methods

  • Term loans: Loans from alternative lenders that require the borrowing business to make regular fixed payments over time.
  • Receivables Financing: These are loans that provide capital against the future income of a business
  • Secured Credit: A line of credit from a financial institution, typically accompanied by lower interest rates and quite difficult to get.
  • Credit Cards: Credit that must be paid back with interest after a certain period (usually 30 days)
  • Convertible Note:  A short term debt instrument that converts into equity. This is usually done when an additional funding round is underway. In this case, an investor loans capital to a startup, but instead of interest payments, the investor gets payments of equity.

Pros: Debt financing is available to almost all businesses regardless of size or industry. It does not require owners to sacrifice any ownership, share profits, or power in company decisions. The money that is received is at the complete disposal of the business with a definite repayment date and amount. A company is not required to send periodic mailings to large numbers of investors, or hold periodic shareholder meetings.

Therefore, if you borrowed $25 thousand at a 10% interest rate and your business gets acquired the following month for $1 million, the lender is only entitled to their principal plus their interest rate. All interest tends to be tax-deductible, and businesses can shop around for the lowest interest rate available.

Cons: Whether your business is successful or fails, repayment is due when it is due. If your business is struggling, it can get very stressful and the debt can act as an anchor to your longevity. Since lenders typically require collateral, businesses that default on loans tend to lose a lot more than the borrowed amount.

Ultimately, both financing methods come with their own benefits and shortcomings. Understanding which is right for you is imperative to the longevity and prosperity of your business. Always make sure to consult with a legal or financial counsel before and do your own research before committing to any path.

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