Understand the Risks and Benefits of Debt vs. Equity Financing

When raising capital for their business, entrepreneurs have a few outside financing options: debt, equity, or convertible notes, which is debt with a provision for conversion to equity. The option that is best for a business depends on its unique needs. Here, the MicroVentures team will review some of the pros and cons of debt vs. equity financing as well as convertible debt, which combines debt and equity financing.

What is debt financing?

Debt is a loan that must be paid back within an agreed-upon amount of time, with interest. Debt financing is often used during seed rounds and bridge rounds, which are designed to get a company from one equity round to the next. Debt is also often used to reduce dilution for the company’s founders and existing investors.

Pros

With debt financing, businesses have a lot of flexibility. Debt financing can work for businesses of any size and for a range of funding needs. Other benefits include:

• Quickly available funds
• Flexible use of funds
• Set terms for repayment
• Tax-deductible interest
• Maintained ownership
• No future profit-sharing

For investors, repayment of debt investments is prioritized should the company fold. In the event that a company must liquidate or is forced into bankruptcy, venture debt is paid back first, putting debt investors first in line ahead of other debt or equity holders. Of course, this is not a guarantee of repayment.

Cons

Debt financing can be limited by credit score requirements, as well as borrowing limits, rates, and the associated fees. Regardless of whether a business succeeds, repayment, including the principal loan and interest, is required. If the business is unable to repay the loan, this could result in default and, depending on the note’s terms, liquidation of company assets.

Although debt financing provides the investor with payments each month, this may leave the company vulnerable during hard times. In order to ensure investors are repaid on a regular schedule, a company may have to forego a needed expansion or liquidate assets crucial to future growth. In some cases, the company may be forced into bankruptcy and be required to liquidate all assets. Although venture debt is repaid first, the company may not be able to liquidate enough assets to fully repay even these top-priority investors.

When to Use Debt Financing

Through debt financing, investors are paid in back each month in return for their investment. If all goes well, the company will repay this debt in full, plus interest payments, within an agreed-upon time frame. Investing in debt prevails vs. equity financing when a company does not experience expected success, as the interest payments may outsize the growth of company stock. In worst-case scenarios, debt financing can also prevent investors from losing the entire amount they’ve put into a company. Venture debt is repaid before all other debt or equity holders, placing these investors at the top of the list if the company is forced into liquidation or bankruptcy.

What is equity financing?

Equity is ownership in a company in exchange for investment capital. It is oftentimes used to reduce the cash flow risk that can be associated with the interest payments on debt financing.

Pros

Unlike debt financing, equity financing frees up cash flow, enabling companies to pour resources into the business, rather than having to pay investors back on a regular basis. When used correctly, this flexibility can help companies to grow faster. Because of this, equity financing can be an attractive option for companies that have limited cash flow.

For investors with the patience and risk tolerance for a long-term investment of this nature, ideally, their ROI will grow in tandem with the company they’ve invested in.

Cons

When it comes to startup financing via equity, the biggest drawback is giving up ownership in exchange for capital. Each time additional equity is issued, the ownership percentage of existing investors becomes smaller as their earlier shares are diluted with the addition of new shares, meaning they now carry less ownership weight. Additional drawbacks include:

• Longer to close
• Time-involvement of pitching investors
• Tend to have higher legal fees than those of debt financing
• Reduced founder control

For investors, the biggest disadvantage of equity financing is the possibility that may lose your investment in its entirety should the company fail, as it is not obligated to repay investors in the event company ceases operations.

When to Use Equity Financing

Equity can prove to be advantageous since it allows the company to place more resources back into the business, whereas debt financing restricts cash flow by mandating that investors get paid back on a regular schedule. This flexibility of equity financing enables the company to grow at a faster rate instead of paying cash out each month. Most companies choose to issue equity because they either currently have limited cash flow, or they expect to at some point in the future to have limited cash flow. Investors usually favor equity in the form of preferred stock, but in some cases common stock is distributed instead.

Convertible debt

Convertible debt, which is issued through a convertible note, functions as a loan with a repayment period and interest rate. However, at the repayment period’s end or at an agreed-upon milestone, this debt carries a provision to convert into equity.

Pros

Convertible debt can be advantageous for founders because it allows the founder to not only delay giving up ownership in the company but is also delays setting a valuation for the company. Another advantage of convertible debt is that it is relatively inexpensive and simple to execute relative to equity. It also does not require monthly repayment like regular debt.

Instead, at the end of the loan period, the principal amount of the loan (plus all accrued interest converts) to equity. This means that founders don’t have to worry about the potential monthly cash flow restrictions of debt.

For investors, convertible debt is often issued at a discount as a “reward” for investing early.

Cons

For startups, a downside of pursuing funding via convertible debt is that it can make some investors wary due to the lack of noteholder control and that the equity terms are set at conversion. For investors, this means that they won’t have a full picture of the deal until the agreed-upon milestone occurs. With that in mind…

When to Use Convertible Debt

The major advantage of issuing convertible debt is that it is inexpensive and easy to execute. Issuing equity can involve costly legal fees and negotiation with existing shareholders which means it can take time and be expensive. Convertible debt allows for a quick turnaround so business owners can get back to running their business. Also, unlike regular debt, convertible debt does not involve monthly repayment. Instead at the end of the loan period the principal amount of the loan plus all accrued interest converts to equity—meaning business owners don’t have to worry about the monthly cash flow restrictions of debt.

Takeaways

Oftentimes, a startup will use both debt and equity at various times to raise funds as the business grows, depending on its current financial situation. Of course, there is no one-size-fits-all approach to financing, and no investment structure is without its downsides. Whichever side of the table you’re on when it comes to debt vs. equity financing, it’s important to understand all of your options as well as the structure of the investment.

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.