QUESTION:
Is it better to get debt or equity financing? What are the advantages and disadvantages of each?
ANSWER:
Nathan Beckord
by Nathan Beckord at VentureArchetypes
Your question is which is “better”; I am assuming this is for a startup, and if so, the answer is, “it depends.” Classic finance theory states that for companies seeking capital to grow, debt is “better” since it’s a “cheaper” form of financing than equity– you take out a loan for a period of time, you either pay (or accrue) interest over the life of the loan, and then you pay it all back– it’s done, it’s off the books, and your debtors go away; whereas equity is considered “expensive” since you are selling shares and the equity buyers may hold such shares into perpetuity. Debt is thus a cleaner structure, and assuming you can put the loan to work in a way that generates a higher return than the interest you pay, debt is typically the preferred way to finance growth.
Now let’s match this financial theory to the reality of life at a startup. A lender’s main concern is that you are able to pay back the loan and interest. To determine this, they like to look at historical financials as well as your balance sheet and any assets on it. Most startups generally have close to zero on both accounts– in short, they can’t qualify for a loan, so the “cheaper” form of financing is not really an option. (The exception is if there are tangible things that can be collateralized; I am working with a startup that is pre-revenue, but has an iron-clad sales contract with a major Fortune 50 customer with guaranteed payments over the next few years; they were able to get a $500k “promissory note”– a form of debt financing– based on the strength this contract).
So startups turn to equity financing. As mentioned this is expensive– you’re giving up a chunk of your company that you generally won’t ever be able to get back– and in early days, most startups must give up a relatively large amount of the company for a relatively small amount of capital; for example, a $3-5M investment from a VC firm in exchange for 25-30% of the company is typical. However, there are other advantages, namely that most equity investors at the seed and Series A rounds tend to get very active in advising and guiding the company. Similarly, there’s often a marketing boost that comes from raising a round from a well known angel or VC.
In short– debt is “better” if you are the rare startup that can finance the company with it; but the ancillary benefits of equity financing start to level the playing field.
Hi Bryan– as you know, convertible debt is a hybrid of debt and equity, and helps bridge the gap between the two securities. However, I tend to think of a convertible note as more of an equity instrument, as investors are primarily interested in the stock they receive upon conversion, vs. the coupon or interest rate on the loan. Yet convertible debt also provides some incremental protection (e.g. in the event of bankruptcy, debtors get paid back first), so it’s a nice blend.
There’s been a ton of discussion recently on what’s better at the seed stage (convertible notes vs. priced rounds– see this link for a good summary: http://www.dshen.com/blogs/business/archives/convertible_notes_vs_equity/
Personally, for deals under $1m I like convertibles (with a cap if needed), mainly because they tend to be cheap and fast to do. But I’d say the “Series Seed” (uber-simple priced-round term sheets) being used today pretty much levels the score.
What about convertible debt vs equity? As you mentioned, most start-ups can’t qualify for traditional debt.