Why Choose Debt Over Equity?
Why would a startup founder choose to take on debt instead of sell equity to an investor?
Debt can be a scary sounding word. We’ve all heard stories or know people who took out a loan, then things didn’t work out and they were stuck paying it off.
Selling equity to an investor can feel safer because if things don’t work out, you’re often not on the hook for paying the cash back – that’s the risk the investor takes in making the investment.
But there are some great reasons to use a loan to finance business growth and ‘debt’ doesn’t have to be a scary word at all. For starters, if your business doesn’t have the financial capability of paying a loan back with a percentage of revenue, you’re probably not going to qualify for a loan to begin with. If you do qualify for a loan, that’s a good sign debt can be a great tool for you.
Let’s assume you can qualify. This page covers some of the most common reasons why founders choose debt over equity.
Before we jump into it, you should understand that there are many great reasons why equity can be a better option than debt. The second half of the page outlines many of those reasons.
Whether debt or equity is your choice, the best way to view either are as financial tools. You’ll get the most value out of either tool when you apply it to the scenario where it’s most useful. Read below to see some of the most common scenarios.
Here are some common reasons why startup founders choose debt over equity:
- By far, the most significant benefit for debt is that it is usually non-dilutive. Most lenders do not sit on your cap table holding equity or warrants for it. This means you keep more of your company and maintain more control.
- Many founders are looking to temporarily delay the sale of equity. They want to grow more so they can increase their valuation and be able to raise more cash when they decide to work with venture capitalists.
- They also understand that by delaying an equity sale until they’ve proven the business model more, they’ll be more educated on where to invest the cash for faster growth. This results in a higher valuation from the investor and better investment terms in general because the founder has helped to remove some risk from the business.
- The cost of equity capital can be very high. Even in the case where a loan from a venture lender might have a cost of capital equivalent to 20% or 30% interest on the loan amount, that may be virtually nothing compared to the cost of 20% or 30% of the total value of your company at an acquisition. Especially when you take into account all the startups where an acquisition turns out to be more of an acqui-hire – the investors are often the only ones getting anything out of the deal. In fairness to the investors, these cases often result in the loss of at least some of their investment. But, still, they’re the only one’s getting cash back.
- A bridge between rounds. This is a very common use case for debt. Things haven’t gone exactly according to plan, but you need cash. If you raise on equity now your terms will not be as good as when the metrics look better. Even if you choose a convertible note where the company valuation can be delayed to a later time, the terms on the note will reflect the state of the business and the investor will often ask for a discount off the company value at whatever round that note ends up converting. Discounted convertible notes can sneak up on you later and become very expensive. So, debt is becoming a much more popular option in between large equity raises.
- It’s pretty common to see founders use debt as the cap on a large equity raise. The business may have a justified need for raising $10 million, but the founders don’t want the dilution that comes with raising over $8 million. So they take $8 million from investors and use a $2 million loan to cap it off.
- In addition to maintaining more control over the business, many founders are wary of bringing too many people onto their cap table. Selling equity brings partners into the business. Managing investor relationships takes a lot of a founder’s time. If you don’t end up getting along well with the new investor that is now your partner in the business, good luck. These situations can be difficult. Choosing debt over equity can reduce the number of investors on your cap table and reduce the chances that you end up doing a deal with someone you’re not a good match with.
- Venture capital may be scarce. The financial market collapse and the beginning of covid are a great examples of this use case. For many months investors held their cash much tighter. Funding rounds were delayed and some cancelled completely. Many markets were under water and the world was uncertain how quickly the economy would come back. Venture capitalists and their fund LPs were justifiably concerned. Lenders who had an available fund to lend from did very well during those times and became a great source for founders looking for capital.
Ok, let’s flip this around. Why would you choose equity and not debt?
- Here’s a common one – you may be in a scenario where bootstrapping it just isn’t possible and debt isn’t an option without personal guarantees. Maybe you’re pre-revenue, or maybe your product community has grown well but doesn’t the monetization model totally proven out yet. Either way, you must have cash and your pockets, and those of your friends and family, are not deep enough. Angel investors and venture firms are a great fit.
- Your business may be growing well, but some of the metrics aren’t quite there yet for the lenders. For example, you may still be burning a lot of cash every month even though revenue is growing well. The amount you’re burning may be outside the comfort zone for a lender. This is a great fit for an investor looking for equity who will to take more risk.
- You may be looking for a strategic partner that is more than a source of funding. The expertise of their firm, the brand value of the firm (credibility to your company with the press and the market), and the experience of the investor(s) themselves and their long-term guidance may be more important to you right now than just cash alone.
- While there are certainly many lender options out there that operate as an experienced partner, a lender may only be involved with you for the term of the loan. An investor that owns equity in your company is with you to the end and has a vested interest in seeing a good outcome that stretches longer than the lender.
- Be brutally honest – you may have no idea when or how you will hit profitability. You may have a model that shows a roadmap, but most of your variables may still need to be proven or figured out. Equity provides more time to figure it out. Qualifying for debt mostly relies on you having already figured out a lot of it. Generally speaking, those who qualify for debt are not looking for time to figure out the business model anyway, they’re looking for cash because they’ve figured it out and know where to invest it for faster growth.
- Your business might have a very long customer acquisition payback period (your sales cycles and time to revenue may be long). You invest money in marketing and sales activities knowing that it could take you a year or more before the revenue from a closed deal pays you back. In early stages where customer numbers are lower, that makes it very difficult to invest revenue back into the model so you can self-fund faster growth. Equity provides time to get through long sales cycles and the cash to invest in growth prior to having those acquisition costs paid back.
There are plenty of other reasons and use cases for both debt and equity. Neither one is good or bad, just financial options that can be great tools at different times on the journey of growing your business.
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