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Today, there are more ways than ever for entrepreneurs to secure financing to make their business dreams a reality. Whether that funding is used to help a business break into a new geographic market, secure talented team members essential for the business’s continued success, or even acquire a company’s first customer, there is no shortage of options at the fingertips of today’s founders. However, the sheer volume of funding options can obfuscate rather than illuminate the path forward for today’s burgeoning founders and leadership teams. The goal of this article is to clearly and concisely lay out the benefits and drawbacks of equity and debt financing, two of the most common funding methods used by startups today, so that you can make an informed decision about the best way to accomplish your goals.
The fundamental relationship between companies and those who help fund them is that each party benefits in some way. The question is, will the requirements of one party align with what the other party is willing to give up?
Investors, those who fund businesses, demand compensation for the money they invest. That compensation is directly tied to how risky the perceived investment is. Money in a savings account does not earn much interest (about half a percent per year on average as of the beginning of 2024), but the money you invest is also secure and available at a moment’s notice. An investment in a startup company, however, is often very uncertain, and it may be years before an investor sees a single dollar of their money returned from the investment. Because of this inherent riskiness, startup funding can be notoriously expensive.
Luckily, it’s not all bad news. The adage, “it takes money to make money” is no less accurate today than when Plautus said it ~2,200 years ago. The purpose of external funding is to get a company over a hump and past some constraints that have limited the business in some way. If planned well, the result should be a mutually beneficial relationship where both parties win. The investor gets their return, and the company, despite sacrificing some amount to the investor, finds itself in a more prosperous state than before.
Now that we know why funding matters, let’s look at the options.
The question of equity financing vs. debt financing is one of the most basic choices that must be made when looking at startup funding, but oftentimes the choice will be made for you (more on that later). Both equity and debt financing have distinct benefits and drawbacks.
Debt financing gets a bad rap. Let’s be honest, even saying the name out loud gives some people the chills. If you say “debt” three times in a mirror, Dave Ramsey will appear behind you yelling at you to cut up your credit cards. However, despite the negative connotations associated with debt and debt financing, it is also the method of financing most familiar to the general public. Credit cards, auto loans, and mortgages are all types of debt financing. Most people are familiar with debt from a consumer perspective rather than a commercial perspective. The latter is debt owed by a business to a lender.
Businesses borrow money from lenders and promise to pay that money back, plus interest, over a certain period of time. The business benefits by getting access to additional liquidity that can be used to pay operating expenses, purchase expensive equipment, or even pay down higher-interest debt. The lender benefits by earning interest on the loaned funds over the life, or term, of the loan.
Let’s look at an example. Assume that you are starting a landscaping business and that you need $10,000 to buy the necessary equipment. You approach your bank, supplied with $2,000 of your own money and a buttoned-up business plan created by Hilo, and ask for a loan for the remaining $8,000. The bank agrees to loan you $8,000 at a fixed 5% annual simple interest rate, and the principal (the original amount borrowed) plus interest is due in 2 years. That would mean that in 2 years, you would have to pay the bank $8,800 (the $8,000 originally borrowed plus $800 in accrued interest).
Debt investors, or those who lend money, tend to be risk averse, meaning they want the business to play it safe and NOT swing for the fences. This is because the terms of the debt are contractual, meaning that the borrower must make repayments based on the timing and amounts specified by the loan documents. On the one hand, this is great for lenders because if the company is doing well, the lender has a steady guaranteed payment coming their way regularly. However, if the company does extremely well, the lender does not get an extra dollar. Worse still, if the company takes a more risky approach and things go south, the company may no longer be able to make its payments. In this situation, the lender may have to renegotiate the terms of the debt or even pursue legal action against the company, which can be a costly process from both a time and financial perspective.
Debt is generally considered cheaper than equity. This means investors are willing to accept a lower return on a debt investment as compared to an equity investment. This is due to its structured payments and the fact that debt investors receive their money back before equity investors do upon the liquidation of the company.
Shareholders, partners, members, or simply equity holders, are parties who have invested capital into a company with the goal of sharing in the upside potential of the company’s operations.
Equity holders may be operators/founders of the business or third-party investors. Third-party investors will often have varying levels of involvement in the company and oftentimes will be more involved when the company is in its earlier stages or if they have expertise in the industry in which the company operates.
Funds received from equity investors do not come with the associated interest payments that debt financing incurs. Because of this, many people view equity financing as the more affordable option. However, equity financing is not without cost. Namely, the costs associated with equity financing are the lost ownership percentage and the related potential upside in the company should it do well.
If you were to start a company today with $1,000, you would own 100% of that entity, the assets and liabilities that it holds, and, assuming that the company turns a profit, you would also be entitled to 100% of the profits generated by its operations. However, imagine that in order to start the company, you needed $5,000, but still only had $1,000 of your own money to invest. What then? Well, if you were to pursue equity financing to get you to the $5,000 needed to start operations, you would likely have had to give up 80% of the ownership of your company. That would mean that if your company generates $1,000 in profit in year one, only $200 of that is yours. The other $800 belongs to your investor.
What’s more, equity is a permanent financing arrangement. Once an equity holder invests, they own a portion of the company until they choose to sell their stake. The $800 lost may not seem like a large cost, but let’s look a year down the road. In year two, the company generates a net profit of $100,000. $80,000 of that goes to our generous investor. It is starting to seem like that $4,000 he invested a couple of years back really paid off for him and cost you quite a bit.
That begs the question, why would anyone choose equity financing over debt financing? After all, in our debt financing example business, the cost of capital was $800 over two years, regardless of how much money the company made from operations. For our equity-financed business, on the other hand, the cost of capital was $80,800.
Well, for starters, equity financing is often the only choice for asset-light startups. When a company doesn’t have physical assets to secure a debt investment (collateral), the risk of that investment, and the associated cost (interest rate), rises. For a company that is brand new, the risk is often too great to justify a lender investing at all.
Equity investors, on the other hand, are more willing to take risks because they have an unlimited upside (a percentage of company profits) and the same capped downside (the amount they invested) as a debt investor.
There is no best method of financing your business. Like almost all things in life, it must be viewed in the context of each party’s specific situation. Pure debt financing, pure equity financing, and a blended approach that incorporates both avenues are all acceptable, and often advantageous, routes depending on the position the company finds itself in. Now I know what you’re thinking, “I just read this entire article and have been left with nothing but a vague platitude.” Okay, fair enough. While we can’t tell you with certainty what is the best option, here are a few examples that highlight some of the macro-level considerations you should be thinking of.
It is 2013 and John S. has just decided to start a hardware store, Main St. Tools. Previously, John was the regional manager of Local A Hardware, and managed a chain of 5 hardware stores in his area. John plans to sell robust, state of the art tools and durable, long lasting building materials to local contractors, homeowners, and DIY enthusiasts. John also owns a commercial building in a well known area of town that he plans to use as the storefront of his hardware store operation. The building is in good shape, but the parking lot needs repaving before the store opens. The building has a 30 year mortgage that John took out on the property three years ago. John needs $50,000 in order to purchase his initial inventory and repave the parking lot so that customers can begin shopping at his store. He thinks that he will begin to start getting consistent revenue in three months after work on the parking lot begins.
Experience - John has worked in the industry and he is looking to start a business. Prior industry experience can be reassuring to both lenders and equity investors.
Hard Assets - John plans to sell high-quality, non-perishable goods that should retain much of their value. He also owns a property that could be put up as collateral. This is a good sign for lenders as they know that if businesses were to turn south, they would likely still be able to recover some money by selling these assets.
Interest Rates - In this hypothetical scenario, John is opening his hardware store in 2013, during a time of extremely low interest rates (ZIRP) in the US. When a country’s central bank adopts a monetary policy that aggressively lowers rates, lenders throughout the country follow suit. As such, debt financing becomes cheaper during these periods.
Consistent Revenue - Lenders prefer to invest in companies that have steady, predictable cash flows from operations. This ensures that the company will always be able to make interest payments as they come due.
Delay in Revenue - Because the parking lot will take 3 months to fully renovate, John’s hardware store will have no revenue, or at best, inconsistent revenue over that period of time. This increases the risk of the investment to the lender and could cause them to charge John a higher interest rate.
High Amounts of Debt- The building that John will be operating his business out of already has a mortgage on it. Too much debt, whether held by the company or the company’s owner can be a red flag for lenders.
It is December 2023 and Jen S. is exploring financing options for her new company, Chart-IT. The company will operate via a software as a service (SaaS) model and will offer a specialized CRM plug-in for hospitals that Jen believes will revolutionize the way that doctors and hospitals interact with their patients. The technology is still being developed and while there are a number of institutions who could potentially benefit from this offering, the company has no revenue.
Jen is confident that her past role as CTO of a large pharmaceutical company and her existing network of executives within the industry will open doors for the product once it is ready to be rolled out to the market.
Initial projections indicate that the adoption of the new technology may be slow as the offering will need to be within the strict regulations of the healthcare space. Further, Jen believes that once the first hospital in an area adopts Chart-IT, other hospitals will follow suit, which would lead to large bumps in revenue. Jen also admits that it may be difficult to accurately project the timing of these increases in revenue.
SaaS business model- Chart-IT will be operating as a SaaS business, this could be both a pro and a con in this situation. SaaS companies have become a critical part of the global economy. As the companies have become more reliant on technological infrastructure, there have been more opportunities for third-party vendors to help create efficiencies via SaaS offerings. This large B2B market for SaaS companies provides an ideal situation for significant financial returns, which is very attractive for equity investors.
Despite the fact that SaaS is a business model that has experienced significant successes (especially recently), there are also risks associated with this business model. SaaS companies often operate in an “asset-light” environment, meaning the majority of the value of the company is derived from technological and human capital, while physical assets (such as machinery and inventory of physical goods) is a lesser, or non-existent, portion of the company’s value. This can be a risk for both equity and debt investors as the value of these less tangible assets can evaporate very quickly if the market does not adopt the company’s offerings. Equity investors are, overall, more willing to accept this risk of loss.
Avoid High Interest rates- Chart-IT is starting up in late 2023, and over the last 18 months the US Federal Reserve has increased the Federal Funds Rate by over 5% in an effort to rein in inflation. Lenders across the country have followed suit which is making debt financing far more expensive than in previous years. This increased cost of debt financing is a “pro” for a potential equity financing, often simply by necessity.
Lots of potential- As the founder of Chart-IT, Jen believes that this technology can make a lasting and substantial impact on the medical industry. This type of conviction that a product or service will revolutionize an industry can entice potential equity investors with the potential for outsized returns on their investment.
Clear benefit- Chart-IT focuses on the medical industry and their goal is to help patients who are dealing with injury and illness. Companies that focus on developing products and services that benefit humankind are often viewed favorably by ESG and Impact Investors
Networking benefits- Jen has a strong background in the markets that Chart-IT is looking to participate in. As CTO of a pharmaceutical company, Jen has likely made numerous connections with high-net-worth and ultra-high-net-worth (HNW/UHNW) individuals. These contacts are a perfect group to approach for early-stage equity financing for a startup.
SaaS Business Model- Despite the fact that SaaS is a business model that has experienced significant successes (especially recently), there are also risks associated with this business model. SaaS companies often operate in an “asset-light” environment, meaning the majority of the value of the company is derived from technological and human capital, while physical assets (such as machinery and inventory of physical goods) is a lesser, or non-existent, portion of the company’s value. This can be a risk for both equity and debt investors as the value of these less tangible assets can evaporate very quickly if the market does not adopt the company’s offerings. Equity investors are, overall, more willing to accept this risk of loss.
Specialization- Chart-IT’s technology is very specialized. While this specialization and targeted market focus can be a good thing, it increases the risk that there are not enough potential customers in the market who will adopt the offering in order to make the company profitable.
Pre- Revenue: Chart-IT has not secured their first customer. The company is in the “Pre-Revenue” stage which is an extremely risky time for the company. During the pre-revenue stage, the company often has a very high burn rate and many companies are never able to convert their first customer and end up closing down.
Regulations- The medical industry has numerous regulatory hurdles that could cause delays in Chart-IT’s technology being adopted by hospitals. These delays increase the risk of any investment.
Early go to market- Chart-IT’s revenue, once it goes to market, may be lumpy and uneven, with large increases that are difficult to predict. This causes difficulties in growing the business and planning the next steps.
As you can see, both hypothetical businesses have a number of pros and cons associated with them. Overall, we can see that Chart-IT has more risks, both internal and external, than Main St. Tools. That does not mean that Chart-IT a bad investment or that Main St. Tools is a better one. It simply indicates that they may have to go different routes to get the capital they need to scale their businesses.
Both financing methods have their own set of advantages and challenges. Debt financing can provide necessary capital with the obligation of regular repayments, making it a suitable option for startups with predictable cash flows and tangible assets. On the other hand, equity financing, though it involves sharing ownership and potential profits, offers a flexible approach without the burden of fixed repayments, which can be advantageous for high-growth, asset-light startups. Ultimately, the best financing strategy is one that aligns with your business model, risk appetite, and strategic vision, ensuring sustainable growth and success for your entrepreneurial journey.
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