Startup Debt vs Equity Financing – Pros and Cons
There is more than one way to fund a new business venture and fuel its growth. For almost all, it is going to require bringing in outside money at some point. Even if that is only to multiply what is working or to create a source of emergency capital. The two primary options are to either leverage business debt financing or fund raise for equity investors.
I’ve started up eight companies (businesses) in the last 25 years and used just about every combination of Debt and Equity imaginable.
Each method can carry its own pros and cons. It is vital for entrepreneurs not to blindly follow the herd just “because everyone else is doing it.”
There is an emerging third option that I’ll cover in a subsequent post called a Token Raise, which although being mainly associated with an ICO (Initial Coin Offering), can be combined with a traditional debt or equity fund raise.
Debt Financing means when a firm raises money for working capital or capital expenditures by selling bonds, bills, or notes to individual and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise to repay principal and interest on the debt.
While non-recourse corporate financing is always preferred, some new entrepreneurs may also have to decide whether they will use their personal credit to get off the ground.
The Advantages of Debt Financing
- You retain full ownership and control of your business, since the lender does not claim equity in the company.
- Once you repay the amount you borrowed plus interest, you have no further obligations to the lender, who has no claim on the future profits of your business. Therefore, if your company is highly profitable, you keep a larger portion of the earnings for yourself than you would if you had to share it with investors who have equity in your business.
- Interest on debt can be deducted from your business’ taxes, lowering the cost of the loan to your company.
The Disadvantages of Debt Financing
- Since debts must be repaid within a certain time frame, you could be in a difficult position if your company experiences cash flow problems or does not generate as much revenue as anticipated. If your company can’t repay its debts on time, you may be forced to liquidate assets or shut down your business altogether.
- You could be held personally responsible for repayment of the loan, even if the formation of an entity such as an LLC creates a legal separation between yourself and your company.
- Debt could make it difficult for your business to grow, since you’ll have to use part of the revenue to repay debt instead of reinvesting it in the company.
- If you carry too much debt, your company will be viewed as high-risk, making it hard to attract equity investors.
Equity financing is the process of raising capital through the sale of shares in an enterprise. Equity financing essentially refers to the sale of an ownership interest to raise funds for business purposes. Equity financing spans a wide range of activities in scale and scope, from a few thousand dollars raised by an entrepreneur from friends and family, to giant Initial Public Offereings (IPO) running into the billions by household names such as Google and Facebook.
There are no fixed repayments to be made. Instead, your equity investors receive a percentage of the profits, according to their stock. Though there can be hybrid agreements which incorporate royalties, and other benefits to early investors.
Typically, the term sheet will be summarizing what are the terms of the equity round.
The Advantages of Equity Financing
- The biggest advantage of equity financing is that the investor assumes all the risk. If your business fails, you don’t have to pay the money back.
- Without loans to pay back, you’ll have more cash available to reinvest in your company. Your company could grow faster than it would if it were saddled with debt.
- A deal with a well-connected venture capitalist or angel investor often comes with other benefits, such as access to key business contacts.
The Disadvantages of Equity Financing
- You must share ownership and control of your company with your investors. You’ll have to share your company’s profits with the investors. You won’t have the freedom to make decisions regarding your business without the investors’ approval. You may not agree with the way they want to run your company.
- The only way to regain full control of your company is to buy out your investors, which will probably require you to pay them more than they originally gave you.
- It takes a lot of time and effort to find the right investors for your company. Ideally, you should choose investors who share your business vision and goals and with whom you get along.
- Raising equity capital is more complex than getting a loan. It requires compliance with numerous federal and state securities laws and regulations. You’ll have to issue periodic reports to shareholders and schedule periodic meetings with them, which could add significantly to your overhead costs.
I can’t state this strongly enough, but the biggest mistake the majority of Startups make is that they try to save money by doing everything themselves. Most find out too late that they would have saved time any money by investing in retaining the services of a Mentor. You should know the pros and cons before you start searching for the money. Understand which may be the most beneficial for your current stage of business and how it could help or hurt for future fundraising needs.
Furthermore, make sure that you have the right legal counsel representing you. Make sure they are corporate lawyers that have closed several transactions before you even consider engaging them.
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