Today, entrepreneurs look for two options when it comes to raise funds for their business namely, equity or debt. A loan which is to be repaid on specified time along with interest is referred as debt while in exchange of money; the ownership portion offered to investor is called as equity. Most commonly debt is being used during bridge rounds and seed investment rounds for getting an organization from a Series A to B to C with the help of venture capital firm. Mainly, debt is used to reduce the dilution of an organization’s founders as well as existing investors because the share of existing investors becomes smaller, every time equity is being issued. On the other hand, equity is being used for reducing the risk of cash flow related with the interest payments on debt. It has been observed that most of the time a startup business uses a combination of equity and debt financing as they grow. This combination might be seen as prudent because they are used in different funding situations and for that one must know the pros and cons of each alternative.
Startup Equity: When to Use Equity to Fund Your Business
Equity might prove to be benefited as it permits an organization to place certain resources back into business while debt financing limits cash flow by making mandatory for investors in getting repaid on a specific time. The flexible nature of equity financing allows an organization to develop at fast rate rather paying cash every month. Many organizations choose to issue private equity as either they presently have limited cash flow, or in concern of future cash flow limitation. It has been observed that investors mainly favor private equity in the preferred stock form but in certain cases instead of this common stock is being distributed.
As long as private equity investment wait, the ROI grows along with an organization they back. The private equity amount decides the size of investor’s voice in an organization and those who have large shares might be serving the role of board member or mentor in the company. And it usually happens that as the investor has a portion of ownership so before taking any kind of big decisions, the organizations asks them or consults them.
Drawbacks of Equity as a Funding Source
Despite so many advantages, equity investment does have certain drawbacks. One of the biggest cons of equity financing is the possibility that your investment might not be paid back in case the company is not obligated to pay you back, if it fails. Also, every time during an additional investment round bring in new shares, the previous ones are diluted carrying less value. Lastly, it takes longer time to close equity deals and the legal cost is quite high as compared to debt financing.
Startup Debt: When to Use Debt to Fund Your Business
Debt financing is money that has to be pay back and it can take the form of a line of credit, a merchant cash advance, a loan, or a credit card. Using loan for obtaining capital or growth funds for starting a business is referred as Debt financing. Debt financing allows businesses to get the money they require for their business without giving away equity. Provided businesses can continue with the payments of interest and pay off all they owe and will get to maintain all the remaining proceeds in the coming years.
Drawbacks of Debt as a Funding Source
Payment obligations: Lenders expect that you pay off your debt like clockwork even in difficult times as they don’t have stake in the business.
Assumption of all losses: You are the sole responsible for the all the risks, when you are the only owner of the business. When you fail then not only you need to assume your losses, but those of lenders too, as they can sue you if you can't complete your agreement.
Many entrepreneurs think that the best and common form of raising money for their startup is equity financing. It involves the usual pitching to venture capital firms and investors for raising money in exchange for equity in company. However, these are not only way of raising money for company rather both equity and debt financing can help in other cases also. Additionally, nothing is perfect so as the investment structures whether debt or equity financing.