Debt versus Equity in the Startup Venture
Both debt and equity funding have significant advantages for the startup venture. The primary advantages (and disadvantages) of each and the are discussed below:
- Debt Capital – Liability or obligation owned to another person or institution and legally required to be paid by a specific date.
- Ex. Bank loans, government guaranteed loans, lines of credit, credit cards, mortgages, notes payable, bonds, accounts payable, trade credit, home equity, leasing contracts, etc.
- Advantages of Debt
- Less costly than equity since most interest rates are less than what investors would require as a rate of return.
- With debt, you don’t give any ownership of your business.
- Disadvantages of Debt
- Debt has less flexibility, since you are required to make constant and periodic principal and interest payment similar to a home mortgage.
- In seasonal businesses or a business with a sudden downturn in sales, debt payments can cause a cash crunch.
- Generally, the entrepreneurs must personally guarantee any debt, which subjects their personal assets to potential liability.
- Best Situations for Debt
- When money required will be used for fixed assets
- Lenders look for some kind of capital in order to take a security interest.
- Use debt when your business needs a line of credit – the advantage is that you only pay interest on the amount of money that you’ve drawn down.
- Equity – Money raised from owners of the business through the sale of Common Stock, partnership interests, other ownership based interests.
- Note: The major sources of equity capital are current owners, new partners, private investors, customers, suppliers, angels, investment bankers, venture capitalists.
- More flexibility – No collateral requirements for equity capital and repayment terms and conditions can be tailored to needs of the business.
- Repayment is generally put of until the business exceeds breakeven or reaches a certain level of profitability.
- Note: It is increasingly common to push of repayment until the exit event.
- It is also a good way of raising large amounts of money for the business.
- Equity is very expenses (the rate of return required by the investor)
- It entails ownership in the business.
- Note: Ownership generally entails the ability to give input as to the big picture management of the business. Such as a seat on the formal or advisor board.
- Some investors are more active than others in the business. This can be a blessing or a burden.
- Best Situations for Equity Funding
- Equity is most suited for startups that require large amounts of working capital or involve a new product launch.
- Again, banks are reluctant to lend cash to businesses for working capital – especially when they are in the startup phase.
- They like to finance the assets found at the top of Worksheet 1, b/c they can liquidate these assets in the event of business failure.
- Investors are willing to take on the risk of a startup for the higher reward. They fund high-risk startups, new product launches, new marketing initiatives, and major growth or expansion of a phase of the business.
- Any items found at the bottom of worksheet 1 are better suited for equity type investors, due to the higher risk to the lender.
Debt to Equity Ratio
The debt to equity ratio is simply the amount of money the business owes in debt to the amount of money it has taken in via equity financing. A company must maintain a debt to equity ratio that meets the capital needs of the company while not making the company fiscally vulnerable. An investor will be reluctant to invest in a highly leveraged business (i.e., has lots of debt) because the equity investment is always subordinate in priority of payment to the debt.
On the other hand, a company that is financed largely through equity loses the opportunity to deduct the cost of capital from the revenue. Plainly stated, interest paid to a lender is deductible; dividends or distributions of money paid to equity investors is not deductible. Depending on the amount of debt or equity financing, this can be a significant amount of money for the business.
In any event, closely tracking the debt to equity ratio as an indicator of potential vulnerability or as a comparison to industry expectations is important.