Equity vs. Debt Financing: What’s Best For Your Startup?
Aside from bootstrapping, equity financing and debt financing are the two primary avenues for startup founders to raise cash and scale their business.
But what is the practical difference between these two forms of funding?
And, most importantly, how do you determine which option is the best approach for your startup?
We hear a lot of companies raising huge seed or Series A investments, but the truth is that both equity financing and debt financing are viable options, depending on your specific circumstances.
In this article, we’ll put debt and equity financing head to head, discussing the differences and pros and cons of each. We’ll also show you how to determine which option you should pursue.
Table of contents:
- What’s the difference between equity and debt financing?
- What is equity financing?
- What is debt financing?
- How to decide between debt and equity financing
Equity vs. Debt Financing: What’s The Difference?
Equity financing is the process of raising capital through the sale of shares in your company. You receive money from an investor (or group of investors), and in exchange, they receive a portion of the equity (ownership) of your business.
Debt financing is more like a loan. You receive capital from an investor or financial institution, and in exchange, you enter into an agreement that describes how you’ll pay the money back, plus interest.
|Equity Financing||Debt Financing|
|Ownership||You give up some ownership of the company||You retain complete ownership|
|Repayment||Capital doesn’t need to be paid back||Capital does need to be paid back, plus interest|
|Tax||No tax benefits||Interest is tax-deductible|
|Networks||Some investors can provide advice and/or access to networking opportunities||Generally less opportunity to network, primarily because most debt financing comes from institutions|
|Decision-making||You’ll need to consult with your investors||No consultation required|
What is Equity Financing?
Equity financing is a method of raising capital where you exchange equity (partial ownership) in your company for a cash investment.
It’s the most common arrangement for startups to engage in, and it’s generally the type of financing that exists when you hear of businesses raising funding from angel investors or VCs.
Let’s say, for example, that you’re looking to raise a pre-seed funding round.
You’ve developed a good revenue model, you have some early interest from potential clients, and you’ve got a prototype or MVP version of your product to present. You just need some cash to get the whole thing rolling.
After approaching several investors, you meet with one who loves your startup idea and believes in your business plan. They offer you a $1m investment. In exchange, they want 10% equity.
That’s equity financing.
You get the million dollars to spend on product development, marketing, assembling a team to bring the brand to market, whatever you need. But, you give up 10% ownership in the company.
This means they’ll (generally) have a say in any important decisions, such as product direction. It also means that they receive a share of the profits, and a share of the sale value of your company if it gets acquired.
Equity Financing Pros And Cons
Pro: You Won’t Need to Pay Back the Money
When you obtain funding through equity financing, there is no expectation to pay back the funds.
It’s not a loan. It’s more like the investor is buying into your company.
Con: You’re Giving up Part of Your Company
The flip side of this arrangement is that you are giving up partial ownership of the company.
If you give up 20%, say, and in the future, you sell your company for $20m, then you’ll only receive $16m of that.
If you’d engaged in debt financing, however, you’d keep the entire 20 million.
The reason tech startups in particular don’t mind giving up equity for funding is because their goal is to build a company that can have a big exit (tens or hundreds of millions, if not billions of dollars).
In order to scale a company to that size in a short amount of time, equity financing can be a good compromise.
Pro: You’re Not Adding a Financial Burden
Because you don’t have to pay back equity financing, you aren’t burdening the company with financial obligations.
This has important ramifications for pre-revenue companies. If you don’t have consistent income, keeping your expenses low is going to be crucial.
Con: You’ll Lose Some of Your Profits
Giving up some equity means you also forfeit a percentage of the profits your company makes.
This might not be important right now, while you’re in startup mode and not really making a huge profit anyway.
Down the road, though, this can be a more meaningful sacrifice.
Pro: You Have an Opportunity to Expand Your Network
Equity financing often provides an opportunity to tap into the network of your investor.
Networking is incredibly valuable in the startup world. It can introduce you to individuals who can:
- Provide critical advice
- Open opportunities for future funding
- Introduce you to potential new hires
Con: You Don’t Receive Any Tax Benefits
With debt financing, interest on repayments is typically tax-deductible.
With equity financing, however, there aren’t any tax benefits to take advantage of.
What is Debt Financing?
Debt financing is a method of raising capital that involves selling debt instruments in exchange for cash.
In layman’s terms, it’s like getting a loan.
You receive a cash injection from your investor (typically a bank or other financial institution, though some VCs and angels engage in debt financing arrangements), and sign a contract that stipulates your payment terms.
Unlike equity financing, debt financing agreements require you to pay back the capital, typically with interest.
Here’s how it works:
You’ve got a great startup idea, and you’ve started assembling a team. You need a way to keep paying them, though, as you’re yet to get the product to market and generate revenue.
You head to the bank and apply for a business loan. They agree to lend you $300,000, payable over five years at an interest rate of 7% per annum.
That’s debt financing.
You don’t give up any ownership in the company, and your investor doesn’t get a say in important business decisions. You do, however, have to pay the loan back, regardless if your company succeeds or fails.
Debt Financing Pros And Cons
Pro: You Keep Control Over The Company
Debt financing allows you to retain control of your company. That means all decisions are in your hands (and any business partners or co-founders you may have).
Con: You Have to Pay Back the Money You Borrow (Plus Interest)
The flip side of this arrangement is that your investor still needs to get something in return, which in this case is interest on the principal investment.
Over a period of years, this can become quite a significant amount.
A loan of $300,000 with a 7% interest rate on a five-year term totals $105,000 in interest.
Pro: You’ll Retain 100% of Your Startup’s Profits
Because you aren’t giving up any equity to your investors, you’ll continue to receive the entirety of any profits your startup produces.
Con: You’re Adding a New Financial Burden
The requirement to repay the loan means you’re adding another overhead to business operations.
Repayment terms are typically monthly or quarterly, so you’ll need to ensure you’ve got consistent, reliable revenue coming through in order to meet this financial obligation.
Pro: You May Be Able To Take Advantage of Tax Rules
In many countries, interest on your loan is tax-deductible, meaning you might be able to get a tax break if you engage in debt financing.
Con: It May Be Difficult to Obtain
Debt investors will want to know that you’re going to be in a position to meet your repayment obligations.
If your startup is pre-revenue, it’s going to be difficult for them to make this assumption, which can make it more challenging for you to get approved for this kind of investment.
Debt Financing vs. Equity Financing: Which Is Best For Your Startup?
Still not sure whether equity or debt financing is the right solution?
Answering these questions should help get you there.
What’s Revenue and Cash Flow Look Like?
The stage your company is at, and the amount and type of revenue you’re making are going to significantly influence your decision to pursue debt financing or equity financing.
This is because debt financing requires you to pay back the capital, typically in installments. If you don’t yet have any active revenue streams, meeting this obligation is going to be difficult (and institutions will see that and be hesitant to lend to you).
In this case, equity financing might be a more viable option.
How Important Is Control Of The Company?
Do you need to have complete ownership of the company, and any decisions regarding its direction? Or are you happy to give up a little control in order to gain capital to pursue your goals?
Perhaps you’d prefer to have someone else to bounce ideas off, in which case an equity investor might be a suitable partner.
How Much Equity Do You Currently Control?
What does your company cap table look like right now?
If you’ve already got a high number of equity holders, whether because you have multiple founders or you’ve engaged in funding before, then you may be more hesitant to pursue equity financing.
Plus, in this case, you need to ask: where is the equity coming from? Do all equity partners need to give up a share of equity to the new investor? In this case, it’s clearly a group decision.
If, on the other hand, you’re the only founder and owner of the company, you might be more comfortable giving up 10% of 20% equity, as you still retain the majority.
What Immediate Options Are Available?
Lastly, you should consider what your likely options are.
If, for example, debt financing looks like an unrealistic avenue (perhaps you’re pre-revenue), then you might just have to go with the option that’s available.
On the other hand, if you’ve pitched to multiple investors and gotten nowhere, then it may be time to consider applying for a debt financing agreement.
How Fast Do You Want to Grow?
Equity financing will typically give your company more room to grow faster.
Since you don’t have to worry about paying back the investment and it’s not uncommon for investors to invest more money down the line, equity financing is a good option for companies that want to scale quickly.
However, when you take in equity financing (particularly from venture capitalists), there’s an expectation that your company is going to grow quickly, and that your business has the opportunity to be worth billions of dollars.
Those expectations can be a lot to handle and even play a role in your business decisions.
With debt financing, the only expectation is that you pay the loan back. Your lender/investor isn’t concerned with how quickly you grow so long as you pay them back.
While the headlines of startups raising $10M rounds or being sold for billions of dollars sound intriguing, the reality is not every founder wants (or needs) to build a company that size. If that’s not your goal, debt financing could be a better option.
Whichever path you choose, you can be sure of one thing:
Your investors, be they financial institutions or venture capitalists, are going to want to see some firm financials.
They’ll want to know that you have a solid plan for growing revenue, with well-developed spending budgets and a comprehensive understanding of the key metrics that drive business success.
So, get ahead of the curve by bringing all of this data together in a comprehensive financial modeling platform: Finmark.