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Equity vs Debt: which is best to finance your business?

Equity vs Debt: which is best to finance your business?

Figuring out how to finance your business is an important consideration with major consequences. For startups and growth companies, raising capital typically comes in two forms:  Equity capital and Debt capital.

As an entrepreneur, you must be aware of the benefits and repercussions associated with either, or a combination of the two. Both offer situational advantages, however your entrepreneurial judgment and the firm’s position in the market will ultimately determine which is most appropriate for you.

Equity Financing

Equity Financing is often what we associate with startups and growing firms. This later stage of cap-raising is more frequently seen when larger sums of capital, or more mature firms, are involved.

Equity capital can be considered as an cash investment into a company in return for an ownership stake. Typically, you would approach investors and offer a certain number of “shares” (translating to ownership percentage) depending on an investor’s financing capacity and interest in the firm. One characteristic of equity financing is that it is dilutive.

Dilutive means that the ownership percentage a particular shareholder has at a certain point in time is capable of changing depending on future fundraising events. More often than not, changing, in this sense, means decreasing. The reason for this is that equity financing is the exchange of capital for a specific number of shares, and not for a specific percentage of the company.

To highlight this, look at this formula for percentage ownership of a company:

 \mbox{Equity}\% = \frac{\mbox{Number of Shares you own}}{\mbox{Total Number of Shares Issued}} * 100 

Thus, as you issue more shares to new investors in future financing rounds, the denominator (total number of shares issued) increases so the overall expression decreases in magnitude. 

Example

 

Igloo Capital has invested previously in Arctic Ice-Cream, a new brand of natural, Scandinavian ice-creams. They decide against re-investing when Arctic is holding their second financing round.

After the first financing round, Igloo owned 300,000 shares of the 1M shares issued.

This corresponds to 30% of the company.

During the second round of financing, Arctic Ice-cream issues another 500,000 shares, increasing the total number of shares issued to 1.5M. Now, Igloo’s equity stake becomes diluted.

 

As you may notice, offering up a substantial number of shares also means sacrificing ownership rights. This is a hard ask for many entrepreneurs. Investors may have ideas to take the company in directions that may not exactly align with what you expect for your company. However, the right investors have experience and can introduce strategic and operational resources to complement their financial injection. This mix of capital and management resources can be very beneficial for the company in the long-term.

Finding the right investors is key to a successful equity capital raise as they can provide these intangible, necessary resources to optimize business conditions.

Finally, a caveat that usually accompanies equity financing is the typical timeline, often stretching to 6 months from initial investor outreach. This is partially due to investors conducting diligence on your business. Being aware of these types of timelines will allow your firm to judge whether or not you can wait this long before raising your capital.

Debt Financing

On the other hand, debt financing is more common with early stage and fledgling companies. Debt scenarios consist of an agreement to receive money with the intention of repaying it in full (plus interest). The amount of debt receivable can vary quite considerably in terms of size, interest rate, and repayment horizon. This flexibility may benefit early stage entrepreneurs but sometimes may work out more costly on considering interest repayments.

With debt financing, your creditor (be she the bank or investor) is repaid a sum of money each month in return for their lump investment. These repayments mitigate risk for investors, partially, as the investment is slowly being repaid. Moreover, some types of debt (venture debt) require it to be paid off during a liquidation event first before any other creditor is repaid. However, this may be a disadvantage to you over your company’s annual operations, leaving you vulnerable during hard times; this could potentially lead to forced bankruptcy or liquidation even if the company may just be going through a temporary grey period. Moreover, monthly payments can impede growth as profits don’t get reinvested into the firm.

With debt, you do not have to worry about diluting your ownership or introducing external shareholders into your business. You do not have shareholders to satisfy. This leaves all business decisions to you and your team. However, this may restrict the company to be built from internal, biased opinions, whereas with external shareholders, points of view can be provided from alternative perspectives.  

Conclusion

As can be seen, many advantages and disadvantages are associated with each form of capital raise. Both are circumstantial and the use of each depends on the stage of your company and urgency for cash. However, it is important for you to recognize that there are pros and cons associated with the two methods. You and your team should always comprehensively discuss decisions relating to potential financing events.