Running a startup is kind of like joining the circus. One day you find yourself putting on a stellar performance, while the next involves you walking on the tight rope, managing the animals and trying to juggle all in one go. One wrong move and the whole tent will come crashing down.
It’s pretty common too, with 50% of startups failing within their first five years. Small businesses are pulled in too many directions and the money runs out. If your startup is struggling to grow or maintain its operations, then there are no two ways about it; you need to secure external funding.
What is debt financing?
Debt finance is a type loan available for businesses. The borrowing company will be awarded a funding amount as a loan, and is expected to pay back the debt over time, with interest. Typically, this repayment obligation begins immediately in the month after receiving the funding and does not depend on the revenue.
To provide more confidence to investors (and reduce the risk), the finance is usually issued in exchange for collateral. Collateral assets, such as company assets or personal resources like property or vehicles, would be accepted as insurance in case the borrowing business cannot repay the debt.
An example of successful debt financing happened in 2006 with the life sciences firm, Pluto Medical. The goal of their finance was to fund a new equipment facility, with specific terms around loan flexibility and conditions.
After weighing up the benefits of both debt and equity, the firm took on $1million over a 12-month drawdown period. This led to a successful partnership, with competitive loan conditions for Pluto Medical without the need to relinquish control.
When to secure debt finance
The primary benefit of debt financing is that you can take it on without relinquishing an ownership stake in your company. This means that you control the decisions and develop plans to grow, without the need to consider the input of an outside party who may not know your business as well as you do.
Secondly, debt financing is tax-efficient: you can usually deduct the interest payments from your taxable income. It means that, while interest is added to the loan, your business isn’t actually losing out on the added percent- finding the optimal capital structure. These unique income tax benefits are not experienced with equity finance.
Finally, you should choose debt financing when you want more of a say in the loan terms. While it’s not always straightforward, you’re more likely to have a say in the repayment obligations through debt finance than equity finance. This is useful for making loan terms like the interest rate more favourable.
These combined benefits mean that debt financing is ideal for startup companies who only require capital for a short period of time, or are forecasted to experience high company growth.
Types of debt finance
Debt financing occurs in a number of different ways. For example;
- business bank loans
- business credit cards (from the bank)
- private venture capital investors
- line of credit from institutions
Banks can offer debt finance, as well as specific business lenders, incubators and private investors. It’s important to note that debt financing brings variable loan conditions. These are less agreeable if your company is deemed a ‘higher risk’ investment.
Of course, taking on too much debt can cripple your growing business- it’s not exactly “free money”. So having a higher investor confidence in your repayment is likely to result in more favourable borrowing conditions.
What is equity financing?
Equity finance refers to the transaction of a percentage of the business ownership in exchange for growth capital.
Typically, the company issues bonds or raises funding through the sale of shares, whether this is publicly or privately. Then, instead of an immediate repayment period, your company pays only when it profits.
Through the company’s profits and net cash flow, capital providers tie their investment into your level of success. Therefore, they become equity holders and have a say in how the company is run. However, the benefit of tax-deductible funding that we’ve seen in debt finance is not replicated in equity finance.
A successful example of equity finance is Walmart. After a history of debt financing with “every bank in Arkansas and Missouri“, the company went public in 1970. This was an incredibly successful growth strategy, with the original $16.50 shares now worth over $2,000 each.
When you need venture capital
The key factor with venture capital or equity financing is that you have more authority to negotiate on the loan terms. Since you’re issuing private equity to raise capital, the investor(s) are interested in the success of the business. Such a business receives more favourable loan terms than debt finance, since investors are interested in the overall cash flow and profit payments.
Secondly, raising capital through the external finance of equity does not tie your business into interest rates. The funding does not contract you into repayment obligations before your business might be ‘ready’. You’ll only pay back a portion of the retained earnings (loss and profit payments), and will not face penalties for delaying the payment.
Depending on the loan procured, equity finance is better suited to companies focused on long-term outcomes. They make good mergers and acquisitions, and are an option for businesses that may be ‘too much’ of a risk for traditional debt financing. When such a company sells bonds to raise money, there is no repayment cap, so profits are repaid without a limit- but this is the cost of equity.
How to find equity investors
Equity finance brings additional risk for the investor, so you won’t find many banks willing to use this method. Here are some examples of equity investors:
- angel investors
- venture capitalists
- equity crowdfund
- initial public offerings (IPOs)
The most common method of raising capital through equity is by taking the company public. In this way, the public can rally behind the company and increase its popularity, leading to a potential for higher revenue and profits. Likewise, there is an intense due diligence phase to pass prior to the IPO, which leads to transparency for investors, reducing risk.
Debt versus equity
Overall, financing through debt trumps equity cost.
Although the repayment obligations begin right away, the cost of debt is less because there is a limit on the amount you are required to pay back to debt investors.
Instead, equity finance ties your future earnings to the investor, which means an equity investor can receive a percentage of your profits for an unlimited amount of time. Furthermore, you don’t receive the same unique tax benefits and can get forced into unfavourable loan conditions because your business carries more risk.
Debt is cheaper than equity when you calculate the weighted average cost of each investment type. The debt-equity ratio is one of the few indicative financial models available. This one determines how much of company operations are funded by the debt, versus the company’s owned cash.
Having a lower debt-equity ratio means that your business has more financial leverage, leading to better borrowing conditions in a deal. The investor can go about collecting funds without owning a controlling stake in the business. Therefore, you can use this metric to make your company more attractive for investors, and give your business a better chance of securing the funding you need.
If you’re interested in exploring the funding strategy for your company or learning more about non-dilutive funding, our team is happy to chat and point you in the right direction.