A hard decision: is it debt or is it equity?
Which type of financing is more suitable for startups?
For the past year, I've been with Startuplinks, a platform for startups. Here, I support early-stage founders whenever they had questions relating to finance topics. So far, this has been a great experience with inspiring people. I wish all the best of luck in their journeys!!
Many startups were looking for funding. One question that came up was whether it was better to raise equity (from VCs) or to take on debt for future growth.
So in this article, I analyze which advantages and disadvantages there are for each type of financing. Also, I'll tell you in which situations which type of financing might be preferable.
Equity financing is the payment of cash in turn for a proportion of the company's shares.
As seen with many startups, it helps scale the company in a short time. But growth and scalability are not only fueled by money. It is also the group of investors behind who act as members and supporters to see you grow.
Given that it is no loan, there are no fixed repayments. This is also beneficial for startups with yet volatile cash flows.
As promising as this sounds, there are downsides to equity financing. For example, the funding process is time-consuming and competitive. It should be clear that shares are given away and by that also some control over the startup.
Debt financing is taking on a loan. A loan has a defined interest rate, recurring interest payments, and a fixed time horizon. Note that I'll leave out hybrid debt instruments for now.
In general, the application can be "quick" and once the debt is paid, it's gone. Hence, the startup remains in control of the company. The firm can even use the tax shield which results from interest payments (if positive earnings are generated).
But obtaining debt can be hard or even impossible, given that many startups don't have collateral. Especially in the early stages. Also, startups are often considered high-risk companies. (That's also one of the reasons, why venture capitalists surged and cover this gap.) Besides, many startups are still burning cash at the beginning. This makes it challenging to stick to a fixed interest payment cycle. Also, keep in mind that debt financing is a monetary thing. The lender won't act as a supporter or mentor, as in the case of equity financing.
It's worth checking out hybrid models (convertible notes, venture debt or SAFE) which are designed for these situations. To see what fits your needs, ask yourself how much do you need? How fast do you need it? And why do you need it?
- Advantages for equity financing: scalability, mentoring, no fixed repayments.
- Disadvantages for equity financing: time-consuming and competitive fundraising process, shares are given away.
- Advantages for debt financing: quicker process, defined timeframe, tax shield, startup remains in possession of its shares.
- Disadvantages for debt financing: availability of collateral, fixed repayments, high-risk environment, pure monetary transaction.
There is no clear solution when it comes to financing. There are pros and cons for each financing method. Founders should ask themselves what their needs and possibilities are. Subsequently, they should check which method is more suitable for the company.
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