When startups decide to raise capital, they are often faced with the decision of offering debt or equity to their investors. In this blog, we will cover the basics of what debt and equity financing are, the potential risks and benefits, and what to consider when deciding how to raise capital.
What is Equity Financing?
With equity financing, an investor provides capital in exchange for a percentage of ownership. Typically completed through selling shares of the company, equity financing is used most commonly when the company raising money has a relatively immediate need for cash. Equity financing may take the form of instruments such as common stock, preferred stock, convertible preferred stock, or equity units including common shares and warrants. It is common for companies to have multiple equity financing rounds to meet their capital needs and use multiple instruments throughout their funding rounds.
- Common Stock – equity instrument that entitles an individual to receive varying dividends based on the performance of the company and typically include voting rights
- Preferred Stock – preferred stockholders receive priority over common stockholders in regards to dividend distributions but are not entitled to voting rights
- Convertible Preferred Stock – preferred shares that are able to be converted to common stock after a predetermined date or event. The value of convertible preferred stock is determined by the performance of the common stock
- Warrant – provides the right for an investor to purchase a stock at a later date at a predetermined price, but does not obligate the investor to purchase the security
What is Debt Financing?
Debt financing typically requires a fixed payment and is most similarly compared to loans. A company borrows money for their capital needs and is expected to pay back the investment, typically with additional interest. While equity financing forges an ongoing relationship with the investor as they are a part owner in the company, debt financing only enables a temporary relationship; once the debt has been repaid, the relationship with the investor ends.
One of the most common forms of debt financing are bonds, or fixed-income securities that are issued by corporations and governments to raise capital[1]. The company is contractually obligated to pay fixed amounts on a consistent schedule until the principal is paid back in full along with any additional interest. Debt instruments like bonds are risky, but generally present less risks than equity financing making them a commonly used option for financing.
Benefits of Equity Financing
One of the biggest benefits of equity financing is that the company can secure funding without the obligation to pay back the money in fixed payments. This allows the company’s profits to be re-invested into the company without a monthly loan payment. Another benefit that comes from equity financing is that you may develop partnerships and gain industry insights from your shareholders. When investors have ownership, they may be more likely to exercise connections and make introductions that will help the company grow to maximize the investors’ potential return. These connections and insights can be invaluable to any company.
Risks of Equity Financing
The biggest risk of equity financing is loss of control. Equity partners may be entitled to voting rights that affect business operations and growth trajectory. Business owners must be prepared to share control and consider investors’ wishes when they accept equity financing. When selling pieces of the company in exchange for capital, the business owner must also be prepared to share profits with equity partners. The amount of money paid out to equity partners can potentially be more than the interest rates on debt financing.
Benefits of Debt Financing
Debt financing can provide benefits not seen with equity financing. One of the biggest benefits of debt financing is retaining full control of the business. The relationship with the lender ends once the loan is repaid, and the business owner does not have to relinquish ownership. Additionally, loan interest may be tax deductible while the dividends paid to equity stockholders are not, providing a potential tax benefit.
Risks of Debt Financing
The biggest risk of debt financing are the fixed payments the business must pay. A company without predictable cash flow may have difficulty making the payments. Additionally, the company and the business owner will likely need to meet certain credit requirements in order to qualify for debt financing with a reasonable interest rate.
Which Type of Financing is Right for my Business?
There is a lot to consider when deciding whether debt or equity financing is best for your business. Short- and long-term needs, the benefits and risks of each type, available interest rates, and future repayment terms should all be considered when determining which type of financing instrument to utilize. Many companies utilize both types of financing through multiple rounds of financing. Thoroughly consider the needs of your business and the potential benefits of equity or debt financing to make the most educated decision for your business.
[1] https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/bonds/
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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.
