Perhaps the most common method of bootstrapping – which is used by many founders – is using their credit cards to get startups running in the short and medium term. Yet there are a variety of lower-risk financing solutions available in the market – including crowdfunding, private investors, bank loans, venture capital, factoring services, debt financing, and equity financing.
There are two broad categories of financing available to startups that are on the road to the market: debt and equity. Deciding which path is right for your company can be misleading and confusing, and both come with a list of pros and cons.
What do you need to know to make a decision between debt and equity financing? And what do each of these terms mean, exactly?
The difference between debt and equity financing
Debt financing is the opposite of equity financing. While the first is similar to a classic loan – that is, you take money from a party who has to be paid back with interest – the second means selling a stake of your company to investors who in turn expect to receive part of the future profits of your business operation.
In debt financing, the borrowers will be expected to make monthly payments against both the interest and principal amounts. In many cases, the lender will demand collateral guarantees like real estate or vehicles, insurance policies or machinery. In some cases, lenders can accept a mix of those collaterals with accounts receivable too.
Advantages and disadvantages of debt financing
As opposed to equity financing, with debt financing business owners can retain full control of their companies. Banks or lenders will lay down clear and strict terms on the contract, and usually they will offer lower interest and longer repayment periods than personal loans.
A disadvantage may be that borrowers often need to begin repayments immediately, in the first month after the loan is obtained. This can be damaging to a company that is struggling to keep a positive cashflow. So, it is advisable to try to negotiate at least a 60-day period before you begin repaying your loan.
Another disadvantage of debt financing that should be addressed is the likelihood of financial losses for the borrowers, in case something happens with the company and it becomes unable to repay the installments. This can be devastating physically, mentally, and financially – so, if your business has a small profit margin and not many clients yet, your default risk is high and debt financing should be avoided.
Equity financing – what is it?
Equity financing is selling a piece of your company to investors who in return hope to share in the future profits of your business.
Venture capital funds are often on the hunt for startups with the potential to scale exponentially in size in a short period. The advantage is that you won’t have to repay the amount they put in your company until your company is profitable.
The investors are many times entitled to vote in company decisions as they hold shares and are entitled to a proportional part of the profits, when they arrive. It all depends on the term sheet you both agreed to sign when selling the equity.
Pros and cons of equity financing
Equity financing is much harder to get than debt financing. It is best suited for startups in high growth sector like SaaS, marketplaces, and fintech. It often requires the startup to already have traction in sales and be in stages that are beyond the minimum value plan (MVP), to even be considered as an equity financing candidate.
The bright side is that companies with access to equity financing will have much more funds to scale up. They will have some time (until the business is profitable) to begin paying back the new shareholders with part of the profits.
It’s that simple – you won’t have to repay a cent until your operation is profitable. After that, the pressure to stay profitable and increase margins will always be there, which is not a bad thing at all. The risk distribution becomes better for the owners, as a broader group of shareholders have a stake.
In case the business struggles or suffer, you will be in considerable pressure to change and rescue it to profitability again. But if it fails, it fails. Equity financing is all about risk taking and management, for both investors and the startup. Ultimately, if after all attempts to save the business you cannot do it, none of the money needs to be repaid.
The downside to equity financing is that you almost always partially lose control of your company, as many equity finance funds demand voting rights and participation in the company’s decisions. For that you should share a vision, and always remember that they want to make money just like you, and most of the time the suggestions and discussions are for the good of the startup – and that because of their investment you are now stronger and in a better position to beat your competition. What do you prefer – 100% of the profit of €0 results or 60% of €500k in net profits at the end of the year?
So, which one should we choose?
The decision between whether debt or equity financing suits best your startup depends on the type of business you have and whether the advantages beat the risks. Do some research on what is the norm in your industry, and what your competitors are doing. Make some projections of your numbers in a realistic and in a pessimistic way. Then investigate several financial products, and try to analyse which one would best suit your needs in both scenarios.
And of course, in case you consider selling equity, do so in a manner that is legally binding (paperwork instead of only verbal arrangements) and at the same time allows you to retain control over your own company.