About Debt & Equity
Entrepreneurs today have two options when it comes to raising money to fund their company, debt or equity. Debt is a loan which must pay back within an agreed upon amount of time, with interest. Equity, instead, is a portion of ownership in the company given in exchange for an investor’s money.
Debt is most commonly used during Seed Investment Rounds and during Bridge rounds in order to get a company from a Series A to a Series B to a Series C led by a Venture Capital firm. Debt is also most commonly used in order to lessen dilution of the companies founders and existing investors, because every time equity is issued, existing investors share becomes smaller and smaller. Equity is most commonly issued in order to lessen cash flow risk associated with the interest payments on debt.
This being said, many a times startups will use a combination of debt and equity financing as they grow. Using both debt and equity together can be seen as prudent since they are likely used in different financial situations. This being said, it’s important to know the advantages and disadvantages of each alternative.
Before we dig into the advantages and disadvantages we need to introduce one more concept—convertible debt. Convertible debt is issued like debt, as a loan with a repayment period and an interest rate. However, at the end of the repayment period or at an agreed upon milestone this debt converts into equity ownership. We will review the advantages and disadvantages of convertible debt below as well as compare it to debt and equity.
When to use equity to fund your business
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.
As long as those investing in equity are willing to wait, the return on their investment grows alongside the company they back. The amount of equity determines the size of the voice an investor has in the company, and those with the biggest shares of a company may have a role such as mentor or board member. Companies usually give part of board control to investors, and must consult with early-round or larger investors before making big decisions.
Drawbacks of equity as a funding source
Despite its many advantages, investing in equity does have its drawbacks. The biggest disadvantage of equity financing is the chance your investment may not be repaid, as the company you back is not obligated to repay your investment if it fails. Also, each time an additional round of investment introduces new shares, earlier shares are diluted and carry less weight. Lastly, equity deals usually take longer to close and have higher legal costs than those of debt financing.
When to use debt to fund your business
With 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 over equity 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.
Drawbacks of debt as a funding source
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 convertible debt to fund your business
The major advantage of issuing convertible debt is that it is inexpensive and easy to execute. Issuing equity can involve costly legal fee’s 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.
Drawbacks of convertible debt as a funding source
The largest disadvantage with convertible debt is that the equity terms are set at conversion. Meaning, the investor doesn’t know exactly what the deal will ultimately look like until the agreed upon milestone. This being said, convertible debt is usually issued at a discount so that investors are given some preference for investing early.
Summary of Debt vs. Equity Financing
No investment structure is perfect. Even the ideal combination of debt and equity only lessens the disadvantages of each, instead of making them disappear completely. Additionally, the entrepreneurs you’re considering investing with may not offer the type of investment you seek. Before you back a company, make sure you’re aware of when and how you’ll be rewarded for your investment.