Equity versus Debt Financing
Venture capital investment rose to $300 billion globally in 2020, despite the pandemic. And 2021 funding looks poised to surpass it! That’s a significant amount of venture dollars flooding the market—but not every startup stands to benefit from this windfall. Here’s how to decide whether equity or debt financing is best for your business.
Different goals, different needs
First, examine your long-term vision. Equity tends to benefit companies with cutting-edge technology that could disrupt markets. Prime fields include software, drug development, and companies producing medical and engineering devices. The median venture capital (VC) deal weighs in at $9.9 million now, allowing later-stage companies to scale quickly. But most are sold after five to eight years in an acquisition or initial public offering (IPO). And in the meantime, you’re sharing not just the risk, but also control of the company and the potential payoff. Equity investors receive a percentage of the profits, big or small.
Raising equity is also time-consuming, and it forces a valuation of your business. This may not be advantageous if it’s growing rapidly or approaching key milestones.
VC funding isn’t optimal for companies with tried-and-true products and services, or early- stage startups that can remain stable as they grow slowly. Bank loans can be a better option there—as well as grants, crowdfunding, franchising, angel investors, and support from family and friends. Additionally, this model leaves founders in the driver’s seat, allowing for a lifetime of doing what you love; and perhaps even passing the company down through the generations.
Debt financing tends to be a faster process—and the money is released days to weeks after its completion. It also gives entrepreneurs straightforward terms: you know how much you’re paying back and when the installments are due. Plus, business debt can create more tax deductions. But your borrowing power hinges on your credit, collateral, and cash flow to meet payments, which begin quickly and are due regardless of how much income you’re generating. Fail, and you could destroy your borrowing power for the future. (Even worse, if you didn’t separate your personal and business credit, you could jeopardize assets like your home, car, and retirement savings.)
“People assume 100% equity is the optimal capital structure for their startup without considering their revenue or balance sheet dynamics,” says Michael Tannenbaum, chief financial officer at Brex, an all-in-one finance company for businesses. “Recurring revenue and assets (receivables, or similar, that can be turned into revenue quickly) are well-suited for leverage, and should therefore be levered. If you know your business is a critical component of your customer’s infrastructure, you should be more critical of taking dilutive equity.”
Founders need to better understand the cost of capital. Interest on debt is the totality of debt costs, whereas giving up equity means your partner will participate in 100% of the upside of your company.
Tannenbaum adds, "Founders often underestimate this equity cost when evaluating it against cash interest from debt."
Equity means playing nicely with others
“When we invest, we invest not only dollars—the capital—but we also help the companies grow and scale,” says Vignesh Ravikumar, a principal on the investment team for Silicon Valley-based Sierra Ventures, an early-stage venture firm currently on its 12th fund, which weighs in at $220 million.
The upside? VCs can bring a tremendous amount of connections and company-building expertise to the table. And they can guide companies in their evolution, whether that’s an IPO, acquisition, or closure if the business hasn’t stuck the landing.
But that bounty comes with some risk. Half the companies that receive funding remove founders from CEO positions within three years, according to Noam Wasserman, a former Harvard professor of entrepreneurship who is now dean of Yeshiva University's Sy Syms School of Business. And more recent reports show that timeline may have tightened to 18 months.
“With equity financing, there’s the control question and all the other stuff that comes with having a board and investors that join you,” Ravikumar points out.
Company creators have to not only share the reins, but be comfortable with potentially much smaller payouts, Tannenbaum explains.
Startup founders tend to be too risk-averse when it comes to capital structure. Equity is not free; it comes at the expense of dilution.
“I’ve seen a number of examples where startups ‘make it’ and the founders own very little after all the dilution.”
Debt and equity in tandem
As companies pursue equity, Sierra Ventures typically has them raise debt too. Ravikumar says: “You use the equity to drive the business and drive scale. But you have the debt as a backstop—a rainy day fund—in case anything goes wrong.”
Managing Director of Espresso Capital, Will Hutchins, agrees money is best borrowed as part of strategic growth. “The right time to begin thinking about debt capital is when you have found product-market fit and you’ve figured out the direction to go in. Really what you’re looking to do at that point is scale the business.
“For us, people typically are using our capital to invest in marketing, hire, or extend their runway to that next equity round. Because if you’re a company growing at, say, 50% a year, you can use debt to delay your next equity round for 12 months. That can have a tremendous positive impact on valuation and your ability to raise equity at that future time.”
It can also give businesses room to hit certain operational or financial milestones before seeking VC funds.
Tannenbaum remains a big fan of milestone-based financing—and he advises founders to thoroughly explore any large asks before equity rounds close.
“It’s much easier to discuss things upfront. Examples would be the ability to pursue acquisitions, raise debt financing, sell secondary stock, adjust voting rights, or any other potential point of contention. All of this can feel like a ‘re-trade’ to an investor if not addressed upfront.”
At the end of the day, no one-size-fits-all solution exists for raising capital. Debt and equity financing both have pros and cons, which need to be weighed carefully before committing. The decision should suit your business’s focus, credit worthiness, immediate needs, and long-term goals—and the right strategy can evolve over time or involve a tandem approach.
Ravikumar says: “If you’re trying to build a venture-profile kind of business and scale, you get better terms on your debt when you raise venture dollars. So you can get the best of both worlds. And the good news is that you’re not actually required to draw down on your venture debt, but it’s there as a backstop, so there’s capital to keep going if things don’t go as planned.”