Equity vs. Debt Investments: What are different capital options to consider for startups?
No matter what kind of business you run, at some point you’ll likely have to consider raising capital. Whether it’s for research and development, acquiring assets like retail property, or hiring staff, getting access to capital can be a crucial piece of helping your business grow. Here are a few things to consider when making the choice:
Should Startups Choose Debt or Equity?
For many companies — especially ones in the technology sector — raising capital can come down to meeting your capital needs through debt (such as by acquiring a loan) or raising capital through equity (giving investors a piece of your company in exchange for funds).
Debt financing is what you do when you go to the bank (or other lender) and ask for a loan. After the lender assesses your assets, credit history, and the amount you need, they’ll either approve or deny your application and assign an interest rate that makes the most sense given your level of risk.
Equity financing is when investors take an ownership stake in your company (and sometimes decision making power) in exchange for providing you with capital. Like debt financing, the amount you’ll need to give up in equity will depend on how well your business has performed and the assets you’ve acquired. However, unlike debt financing, equity investors do not need to be repaid — if the company fails, funds are returned to shareholders.
There are benefits to both debt and equity financing. Often, startups will use a combination of the two in order to get them the lowest-cost while giving up the least control. Debt can offer firms more flexibility and faster access to capital, in addition to giving up less of your business. Equity can be more affordable, especially in the early stages of a business. Experts suggest debt financing is better for a predictable future (knowing what the money will be used for and how you’re going to pay it back) whereas equity is better when financing uncertainty (such as in the beginning stages of selling a project or monetizing a service).
Types of Financing Options for Startups
Whether you choose debt or equity — or some combination of the two —- to meet your company’s financing needs, there are plenty of options. These include:
- Venture Capital
Traditionally, venture capitalists buy a stake in a business’ idea, in the hopes that in time, the business will grow and pay them a substantial return. The Harvard Business Review compares them to ‘modern day cowboys’ — investors roaming the frontiers of innovation the way cowboys used to roam the wild west. Venture capital is typically used for new businesses that wouldn’t qualify for debt financing, putting money into the infrastructure and balance sheet assets they need to get their idea off the ground.
- Bank Financing
Traditional bank financing (like a loan from a bank) is another option for more established companies to meet their capital needs. Lines of credit, asset-backed loans, or term loans are all typical means of financing through debt. In many cases, the banks may require personal guarantees, impact credit score, and security interests.
Newer credit history, poor history of repayment, and fewer assets in the company can mean a higher interest rate and/or a lower dollar amount loan. The more risk you present to a lender, the more you’ll have to pay them (either up front or long term) to take on your loan.
- Revenue-based Financing
Compared to debt or equity, revenue-based financing can be the best of both worlds: instead of paying interest on a loan or giving away a piece of your company, revenue-based financing allows you to pay lenders a royalty (around 1-10%) on your monthly revenue in exchange for a loan. At the end of the term, you repay the amount of the original loan — a useful alternative to debt or equity financing, especially for startups in the early stages of their business.
Whether you’re looking to raise capital in the near future or just getting your business on its feet, it’s not a bad idea to consider your options. With careful consideration and a little bit of prep work, you’ll be ready to finance your growth in no time!