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, we will review some of the pros and cons of debt and 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 of debt financing
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 of debt financing
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.
While debt financing can be beneficial for income-seeking investors, this can also cut into company revenue and growth, especially during downtimes. To repay investors on time, a company may have to forego expenses that could potentially drive growth. Furthermore, although debt repayment is prioritized in the event a company folds, the company may not have enough assets to liquidate to fully repay these first-in-line venture debt investors.
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.
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.
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.
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 of convertible debt
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 of convertible debt
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…
Oftentimes, a startup will, over time, use both debt and equity 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, it’s important to understand all of your options as well as the structure of the investment.
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.