Starting or scaling a big startup or business usually necessitated looking for investors. That is part of the reason why you should acquaint yourself with the tenets of financing from investors. There are several ways through which you can access funding from investors or financiers. In this article, I shall look at two of them that are commonly used. These are debt financing and equity financing. I will explain how each one works; I will also explore their upsides and also their downsides. In the end, you will be better equipped to at least know how to approach investors.
What Is Debt Financing?
Debt financing is when you get funding that you will have to pay back with interest. Let us suppose you need US$10 million for your startup or business. Debt financing would mean an investor or investors foot the US$10 million and then you will pay back as per agreed interest rates. It is just straightforward like that; most entrepreneurs go this route actually.
What Is Equity Financing?
Equity financing is when you get funding in exchange for shares in your business or company. Let us suppose that you are starting or scaling your startup and you 30 percent of the capital in the form of equity financing. Let us also suppose that 30 per cent is equivalent to US$10 million. This means an investor would give you the US$10 million and in return they get a 30 per cent stake in your business or company. Equity financing has different types some of which are initial public offerings (IPOs) and equity crowdfunding.
Pros And Cons Of Debt Financing
The biggest advantage here is that you retain ownership of your startup or business. The fact that you will have to pay back means the financier is not entitled to own any part of your entity. The other advantage is that you are most likely to quickly get funding as most investors prefer debt financing. The downside is that debt financing is extremely expensive. There are costs involved pus you will be paying back later with interests. The other downside is the risk factor coupled with the pressure to pay back. Failure to meet loan or debt repayment obligations comes with stiff penalties. Thus debt financing can be very stressful if things do not go according to plan.
Pros And Cons Of Equity Financing
The obvious advantage of equity financing is that you are not obligated to pay anything back. You will not have the pressure of making repayments. Often time equity financiers have an ecosystem that you can benefit from. This can include incubator or accelerator programs that can be useful for your startup or business. The obvious disadvantage lies in you not having absolute control. Equity financiers get to own shares in the startup or business so they have a say in decision-making.
In some cases, if the capital you require is a lot they might end up having majority shareholding. I have also noticed that equity financiers tend to bankroll enterprises that require several thousands or millions of US dollars. That is a disadvantage if your startup or business is not that big. Equity financing is not as easy to come by. This is because you are supposed to have a concrete business plan and often times you need to be strategically connected.
Which One Is Better?
The question is largely contextual. Debt financing is generally much faster and easier to access. This means with debt financing you can quickly get the ball rolling. Experts say that there are lesser risks involved in equity financing as opposed to debt financing. They also say that it is easier, in the future, to get investors if you have equity partners. Prospective investors tend to gravitate towards such entities. Of course, there is pressure to repay when dealing with debt financing.
However, there is also a possibility of pressure from equity partners when things do not go as planned. You must also bear in mind that debt financing is expensive at first glance. When projecting into the future over an extended period of time, equity financing turns out to be more expensive. Equity financing is usually suited for ventures characterised by rapid growth or scaling. These are some of the things to bear in mind that influence the choice of either of the two.
In some cases, an investor can set up conditions that end up dictating which one an entrepreneur settles for. Let me share a personal example. I was recently approached by someone who is looking for equity financing for a multimillion-dollar startup. They have already managed to get an investor who has committed to debt finance 70 per cent of the amount needed. The condition that the investor highlighted was that this entrepreneur must find an equity partner for the remaining 30 percent. This is a perfect example that shows two things. One, investor conditions can determine what to settle for between the two. Two, it is actually possible to mix the two i.e. equity financing and debt financing.
This is an interesting subject and there is so much to talk about. If the decision is solely in your hands then some research would be ideal. At the end of the day it should be akin to a cost benefit analysis. The option that produces benefits that overshadow the risks is usually the best. You can also study what is typical in your respective industry. What did startups or businesses before you usually settle for and why? Bear in mind also that you would want to settle for something that does not threaten the control of your startup or business. You can also compare debt financing and equity financing to see which option is most ideal. There is actually a formula used to make such comparisons; it is called the weighted average cost of capital. I will probably detail that in future articles as it is a somewhat technical and lengthy subject.