During the course of their lifespans, most businesses will require an infusion of cash at some point. In the event that founders are unable to self-fund, they are generally left with two options: debt or equity. Often, this choice is dictated by circumstance, but sometimes entrepreneurs have multiple options available to them.
Having started five ventures in the past decade, I’ve explored both of these options. Depending on a number of factors within your company, each type of financing can play a valuable role. Let’s dive in.
If a company needs a substantial infusion of capital — north of a few hundred thousand dollars — or if the company is new, equity financing may be its only option. There are several pros to equity financing. An equity raise requires investors to shoulder the risk, meaning the founders owe nothing if the company fails. Additionally, equity is attractive because the company can avoid diverting revenue to pay down debt.
Generally, equity takes three forms: friends and family, angel investors and venture capital. The first is self-explanatory and usually makes for a fairly seamless transaction. Angel investors may invest anywhere from a few thousand dollars to a few hundred thousand dollars. Venture capitalists, who generally invest primarily in tech and other high-risk, high-reward companies, can bring millions to the table. A word of caution, however, is that venture capitalists seek home runs; they want rapid growth and large returns. Their push for rapid growth can be the death knell for startups.
Equity financing comes with serious strings. Financers will have an ownership interest in the company, will often demand board seats and/or significant voting rights and will generally push for a return on their investment within three to five years.
So, ask yourself if your business can survive without equity financing. Can your business grow at the rate you need to remain competitive in the market without equity financing? If the answer to either of those questions is no, the question becomes, what kind of financing? Is the business capable of rapid scaling with a substantial cash infusion? If yes, venture capital may be an option. If not, founders should seek angel investments, capital from friends and family or a combination of the two.
Either way, can you afford to pay lawyers to make sure that the deal is fair and accurately reflects your intent? Going back to the original question, if your business can survive without equity financing, even if it requires slower growth, maintaining control of your company is often worth more than you realize (particularly if you have access to debt financing for periods in which you need bridge capital). The bottom line: Try to give away as little as you can — both in ownership percentage and rights — to achieve your growth objectives.
There are several pros to debt financing. First, it allows founders to maintain 100% control of their business and they are generally free from oversight — though some lenders may place restrictions on how the money is used. Second, repayment can be spread over terms longer than those that an equity investor expects, allowing the company a decade or more to pay off the debt. Third, interest rates are typically lower than the return on investment for an equity financer, allowing the founders to share in a greater portion of the company’s success. Finally, debt is predictable, whereas an equity exit event is not always predictable.
One of the biggest cons of debt financing is that the lender will usually require collateral or a personal guarantee, risking either the assets of the business or the personal assets of the founders. Second, a company typically must commence making payments on the loan immediately, irrespective of the company’s profitability or cash flow. Third, unlike equity financing, the company must pay interest, regardless of whether the company becomes profitable.
The most important question for evaluating debt financing is, how much do you need? This is perhaps better phrased as, what’s the smallest amount you can get away with borrowing to achieve your growth milestones? Can the company afford to immediately start repaying the debt? Are you willing to personally guarantee this debt, risking everything you own, for the sake of the company’s growth?
Finally, we have convertible notes — a hybrid of debt and equity financing. Essentially, the lender invests capital in exchange for a convertible promissory note, which then converts to equity upon a converting event (usually a future capital raise).
In a traditional equity raise, the most contentious issue is the pre-money valuation. The founders want a high pre-money valuation and the investors prefer a lower valuation. Often, the metrics that inform the valuation are unavailable to early-stage companies, making an equity raise particularly difficult. In that regard, convertible notes are especially beneficial for new companies because the value of the investment does not have to be determined until the conversion event, at which point the metrics for assessing valuation are more readily available.
Convertible notes present the additional benefit of being simpler and faster than a traditional equity raise. A traditional equity investment can take months to negotiate, conduct due diligence and draft multiple rounds of documents. Convertible noteholders essentially get to piggyback on the work of future equity investors while getting more bang for their buck in the form of discount rates (essentially a bonus for investing early).
So, do you need this money now, or can you wait until you have a better idea of how the company will perform and how quickly it can grow? Are you willing to give investors that bonus in exchange for investing in an unproven company?
There is no one-size-fits-all approach to raising capital. The circumstances necessitating a capital raise vary greatly between companies and will largely inform what financing options are available and attractive to the company. Finally, remember that seeking venture capital investors can become a full-time job in and of itself, and that may not be an attractive option for busy entrepreneurs.