Founding a Business
There comes a day in every founder’s life when they have to consider their financing options. To raise capital for business needs, companies primarily have two types of financing options, equity financing, and debt financing.
Most companies, when all is said and done, will end up using a combination of the two, but there are some distinct advantages to both, and depending on the stage of business one option may be more accessible than the other.
In this article from our startup capital series, we’ll break down the what and why of debt vs. equity financing and help you get the clarity you need to determine the right financing path for your company, starting with a quick breakdown of the balance sheet.
The Structure of a Balance Sheet
To get the full picture of how debt and equity financing affect your company it helps to understand first how a balance sheet is structured. A balance sheet shows a company’s assets, liabilities, and equity and is one of the three core financial statements for a business. The remaining two are your income statement and statement of cash flow.
The reason a balance sheet is called a “balance” sheet is because the total amount of assets should be equal to the total amount of liabilities and equity. The practice of accounting has been around practically forever and this core element has not changed (so it’s time to get really up close and personal with your balance sheet if you haven’t done so already).
What is Debt?
Debt is considered a liability and sits on the balance sheet in the liabilities section. Debt is something your company owes to an external party, in opposition to assets, which is something your company owns. Makes sense in terms of the greater “balance” sheet schema. Doesn’t it?
What is Debt Financing?
Knowing a general definition of debt, it is simple to infer that debt financing is capital that you will eventually have to pay back. Or in other words debt financing involves borrowing money, typically from a banking institution, and paying it back with interest after a certain amount of time in accordance with the terms of the loan.
What is Equity Financing?
Equity or shareholder’s equity sits on the balance sheet under the equity section and is different from debt because the company is not held responsible for paying back equity to investors at a certain point in time. However, capital raised through equity financing comes in exchange for a portion of company ownership.
Which Type of Financing is Right for Your Company?
It helps to understand financing in terms of risk to answer the question of which type of financing, debt or equity, is right for your company. For example, if your company isn’t doing very well, folds, and ultimately liquidates its assets, the debt owner gets paid from the liquidation before shareholders (equity owners). This means that the person who owns equity is carrying more risk than the debt owners.
On the flip side, if things go really well in the company, equity holders receive back their initial investment multiplied by the growth in price per share of the company. The debt owner only gets back the loan plus interest.
So this is all to say that debt carries more security than equity does and this is the core difference between the two financing options. Why, then, do some choose debt and some choose equity when debt has more security in the end? We’ll answer this question in the next few paragraphs.
What Do I Want?
Ultimately, the answer to our question “What Do I Want?” is a combination of what you want to do with the capital raised (fit for purpose) and the creditworthiness of the business (i.e. the more mature, stable, and risk-free your business is the more financing options you’ll have available).
Most founders would choose debt over equity all day every day! This is because debt is very cheap IF your company is doing well (alternatively it is very expensive if the company is not doing well). Conversely, equity is very cheap if your company isn’t doing well (but VERY expensive if it is successful). Founders can be quite the optimistic set, so obviously, we’re all banking (pun intended!) on our company’s success!
Not all founders and entrepreneurs are fortunate enough to always be able to choose their preferred financing method. So now, let’s add further clarity to our financing scenarios based on the options available. If you’re a very young company, you don’t have any assets to secure the debt against, or you have no milestones or proven track record to show proof of your business concept then you may not be able to raise debt capital.
Furthermore, if this is the case, a lender would likely require a personal guarantee for a loan where if the company fails the lender can go after you individually for the debt. A personal guarantee is a risky scenario for you and your company is a risky situation for a lender, so equity financing may be your only option to pursue.
For more advanced companies, those with a longer history and major milestones achieved, these companies are able to more easily choose between debt or equity financing. So then how does a company like this choose between the two options? Typically, they have an internal financial analyst that will review their debt to equity ratio and help the business balance the right proportion. The balancing act is to keep your cost of capital as low as possible without exposing the business to too much debt and hence financial risk.
The Debt to Equity Ratio
The debt to equity ratio is a simple measure that takes your company’s total liabilities divided by its equity to show how much debt you use to run your business. This ratio is also used by lenders and investors to determine how risky lending capital to your company is.
The best benchmark for the debt to equity ratio is solvency (i.e. your assets are greater than your debt). Please note, younger companies typically have negative shareholder equity, resulting in “technical or accounting” insolvency but it can still impact your chances to obtain debt finance from traditional lenders. The expectation (from lenders and investors alike) is that your debt to equity ratio improves as the company matures. The topic of solvency (and insolvency) is best served in a blog of its own, so we will save this topic for another day.
To take this determination a step further your financial analyst would also look at your weighted average cost of capital which is a blended cost of capital across all sources including debt and equity. Since each source of capital is expected to generate its own return, the weighted average cost of capital helps take the different weights into account with the goal being to balance the cost so the cost of borrowing can be minimized for the company.
We’ve talked about debt and we’ve talked about equity and now you must be thinking is there some sort of hybrid option that takes into account the best of both worlds? This is where convertible notes come into play for young businesses.
Convertible Notes, A Potential Workaround
Oftentimes when a founder is looking to raise capital from investors a debate surrounding the valuation of the company occurs. Convertible notes were implemented in order to avoid these valuation debates and ensure time was better spent (by both business owner and investor) building and growing the business. At their core, convertible notes start off as debt and convert into equity at a later date.
In the instance of a convertible note, an investor will give you capital that will sit on your balance sheet as debt and will accrue interest. But in lieu of being paid out the interest, the investor stipulates that the founder invests that interest back into their business.
Now when the company matures over the course of 1 to 2 years and can show a proven track record to new investors, it will be easier to place a value on the company because of the company’s history and milestones achieved and hence the terms of equity can be more easily determined and agreed.
At this point, the original investor now gets to convert their debt into equity at a discounted price per share (based on their convertible note terms). Ultimately, because the original investor took on a risky debt investment early on, they can now buy the stock at a discount to the incoming investors (the “discount rate” and/or “cap”). We will cover convertible notes in more detail in a subsequent capital series blog.
This is a complex subject so let’s quickly recap each financing opportunity.
Debt financing involves borrowing money from a lender that carries interest. This type of financing does not dilute your ownership, but can require collateral or personal guarantees, and is an added expense (basically you and the debt provider are banking on your ability to pay this back in the future). Oh, and we’d be remiss if we didn’t mention that interest payments are tax-deductible!
Equity financing is the receipt of capital in exchange for shareholder equity in the company. This type of financing comes with no obligation to repay the money to investors if the business fails, but should the business do well shareholders are owed a share of the profits and own shares of the company. Equity is also governed by federal and securities regulations which means there are a number of protocols in place that will need to be followed to stay in accordance with the law.
One Final Question
Obviously, there are advantages and disadvantages to both debt and equity capital, and depending on your company’s maturity or circumstances both options may not always be accessible. This brings us to one final question: How much capital do you need to raise to begin with? Having an exact handle on the amount of capital you need is always an important aspect of the financing conversation. One way to get a better grasp of your capital needs is to build a financial model through the Simple Startup Academy.
If your company could use further guidance in improving their understanding of their capital needs before meeting with lenders or pitching to investors, consider grabbing some time on our calendar to learn how we’ve helped hundreds of founders and business owners raise capital more efficiently.