Raising money through giving up equity or taking up debt has been the age-old question for most start-ups as they advance from the early-stage phase and move on towards growth and expansion. There are several ways for start-ups to fuel their growth and for almost all, bringing in external money will be required at some point in time. So, which is the better option – to leverage business debt financing or to fundraise for equity investors? In this blog entry, we at Lend East will discuss the pros and cons of both options as we try to outline the better option to take under different scenarios and circumstances.
While there are numerous distinctions and classifications of stages that start-ups go through, we believe that they typically progress through 3 main phases of their business – Early Venture Stage (pre-Series A), The Series A Stage, and The Growth Stage (post-Series A) – which will determine which funding type will be more optimal for their business. To better understand the differences in equity vs debt financing, we will first need to know and understand what these things are.
Equity financing takes place when a venture capital firm (VC) or an investor invests funds in a start-up with the intention of earning back multi-fold amounts made in the form of returns. The start-up need not repay the funds invested to the investor or VC but instead, gives a part of its equity shares to the investing party. This method of financing puts less pressure on a start-up’s top-line and bottom-line but instead, causes it to face pressure from its investors for growth and future revenue. Furthermore, equity investors acquire company shares and have the rights to make certain demands, especially since they become a part of the board of directors and have a vote in business decisions and company strategies which will help them to secure the returns on their investment. However, in the event of a business failure, the VC or the investor is typically the last to get the returns as equity shareholders are on the lowest level of the pecking order.
Debt financing on the other hand is when the VC or investor lends money to the entrepreneurs or founders of the start-up, against a rate of interest for a given period, with the start-ups assets as securities. The start-up will have to repay the principal amount borrowed along with the interest at predetermined rates as well as abide by the terms and conditions set for the debt financing round. Start-ups that undertake debt financing will have debt obligations which adds revenue pressure and is hence usually opted by start-ups which already have a steady and predictable inflow of revenue. A benefit that debt financing has over equity financing is that its non-dilutive; the investor has no equity rights if the debt obligations are duly repaid. While in the short term, the cost of debt seems higher compared to equity, in the long run, it’s cheaper than equity funding.
The table [on the next page] will categorically highlight the main differences in the two options on several dimensions, mainly:
|Equity Financing||Debt Financing|
|Usage and Stage of Business||
In the early stages of a start-up, invested funds serve to typically fuel a start-up’s growth in terms of business development, acquisition of equipment for productivity, and serve as working capital to finance inventory. All these will help the start-up to turn profitable.
In the later stages of a start-up, funds raised through equity financing are used for scaling up the business through widening its market share, acquiring more users and customers and product or service diversification.
Some start-ups do not exactly require funding, but sell a stake of their equity to strategic partners who may unlock certain markets or share their expertise and networks. This is pivotal in bringing the start-up to the next level.
|Debt financing on the other hand can be raised at any point in time for all the same reasons as equity financing if the start-up is comfortable with servicing the debt obligations. Furthermore, debt financing can be taken up to finance or supplement the capital costs incurred in infrastructure, equipment, expansion into a new market and even recurring costs such as salaries, rent and maintenance.|
|Term||The tenures for equity investments are typically long term||Debt financing tenures can be split into short term and long-term debt. Both are commonly used for financial or operational needs of the start-up such as financing the working capital gap, extending their runway and even funding recurring payments as mentioned above.
There are different advantages and disadvantages for short term vs long term debt.
The shorter the loan tenure, the less interest a start-up pays. Typically, short term loans are better-suited for fluctuations in working capital and operational expenses
Long term debt provides greater flexibility and resources to fund various capital needs, and reduces dependence on any one capital source. Furthermore, it also helps in spreading out debt maturities. These loans are also used for long-term initiatives as well as balance sheet risk management.
|Structure||Usually, straight up equity shares may vary slightly based on voting rights and dividend rights. They are split by preference shares vs ordinary shares.||There are many different types of loans that can be taken up by start-ups under debt financing. The most commonly found secured and unsecured types are:
|Cost of Financing||The true cost of equity financing is typically higher than that of debt financing over a longer period of time.||The cost of debt financing is usually higher in the short term and servicing debt obligations can affect a company’s cash flows. However, in the long term, debt financing will be cheaper over equity financing.|
Choosing between equity financing and debt financing is pivotal for start-ups and can affect an early-stage business’s future. Entrepreneurs and founders must assess the stage and use-case of the financing that they will require to efficiently and healthily grow their business. What start-ups can do, is carefully utilize both debt and equity financing at different stages of their business to ensure that they have adequate capital to grow – while being able to satisfy the demands of investors and whatever debt obligations they may have.