Entrepreneurs face a dilemma when it comes to raising capital for their ventures. Startups are all about product development and sales, but at the same time, corporate development such as financing and structuring are equally important. Determining whether to take on debt and repay or give up a portion of a company to raise sufficient capital is no easy answer. Deciding on the sources of venture financing requires a clear understanding of the trade-offs.
By and large, the cost of equity is more expensive than the cost of debt. There are several reasons behind this notion.
The debt holder enjoys extra safety while the equity holder enjoys potential upside. Debt is secured by assets so it is typically safe. Debt holder receives interests as agreed until pay-back time. In case of default, the debt holders would be able to seize assets such as real estate, account receivables, inventories or intellectual properties. Though, when debt is paid back, debt holder does not have any further right. They are protected to secure their assets and, in exchange of risks, they receive interests. They have no voting rights and no upsides.
On the other hand, equity holders who buy shares of the company do not have the as strong right as debt holders to claim the asset when the company goes bankrupt. The equity holders have the right to vote at the shareholder’s meeting to influence management team, hire (or fire) executives, set annual budget, and make significant decision such as M&A or spin-off because they are partial owners of the company. Equity holders enjoy upsides with the founders if the company prospers. However, they don’t go anywhere until somebody else buys their portions of the ownership. Selling equity is like marriage. If everything goes well, you have happy married life, but if relationship breaks, every single board (or shareholder) meeting can be troublesome.
Debt holders are compensated with a scheduled interest payment, regardless of the financial health of the company. If companies fail to make interest payments that debt holders are entitled to receive, they would inadvertently be forced to liquidate. It requires lots of commitments for most of start-up business, but it has its end. Once all obligations for the debt holders are satisfied, you’re free to go. Contrarily, the equity holders are paid dividends in regards to the earnings of the company while their ownership stays as is until there is ownership change.
Both strategies come down to a trade-off between risk and reward. Debt holders are usually risk-averse and are compensated accordingly, while equity holders are rewarded in terms of the profitability of the company and upsides of business. In other words, the higher the risk, the higher the expected return or in this case rewards.
To share you typical venture financing formula, angel investors often pursue 5 to 10% of equity and series A investors take roughly 20 to 30% equity shares of the startup. Numerous sequential financing rounds may dilute the founder’s shares of the company significantly, which can lead to losing control of the company, thereby lowering motivation of the founding members. This also denotes the idea of what the ideal percentage the company should provide for its equity holders. If the market were to be sour, the entrepreneurs will have to suck up the bitterness and sell the shares at a low price. On the other hand, debt can be in the form of promissory notes, convertible notes or line-or-credits with interest rates that can be troublesome if a company does not generate cash quickly enough to pay its debt holders. However, debt is still cheaper than equity if you see long-term implication to your business.
Heavy burden on debt may thwart the entrepreneurs from receiving further equity financing; so entrepreneurs and management teams have to keep an eye on the company’s fiscal management under their belt. Therefore, entrepreneurs should be able to discern the advantages and disadvantages of both financing methods and determining the company’s feasibility accordingly.
(This article was developed with H.G. Byun, a publicist at KingsBay Capital.)