Debt or Equity Financing for startups: What do investors prefer?

Are you a startup owner trying to bring a balance between your debt and equity?

Terms like investments, fundraising rounds, ROI, private equity, venture capital, etc., have gained popularity, given the frequent news headlines about Indian startups raising money. Additionally, these concerns are now receiving more media attention. Startups often ponder upon the question of how they can get funding for their firm or what ratio of debt and equity financing will work best for them.

Startups generally have two major financing options: equity financing and debt financing. Although most businesses combine debt and equity funding, each of these options has some clear benefits and downsides. While equity financing has no payback requirements and offers additional operating capital, debt financing doesn’t require dilution of ownership.

Typically, businesses can either choose between equity and debt funding or maintain an ideal debt-equity ratio. For those of you wondering debt-equity ratio is which ratio? Well, this ratio demonstrates how equally debt and equity must contribute to a company’s funding. The decision between debt and equity frequently comes down to the company’s ability to acquire capital, its cash flow, and how vital it is to its major shareholders to preserve business control. 

Let us dive further into the topic and discuss debt capital and equity capital in detail.

Understanding Equity Financing

Talking in financial terms, equity is nothing but the ownership of a company’s assets that may have some liabilities and debts associated with it. Equity financing is a process wherein a company raises capital by selling a piece of a company’s ownership to raise money. 

Let us understand equity-based financing with the help of an example. Suppose ABC’s company founder needs to raise money to finance his company’s growth. The business’s owner chooses to sell a 10% stake in exchange for $10 million funding from the investor. This brings your company’s valuation to $100 million, and the investor will hold a 10% stake in your company and will also have a say in future business choices.

The types of equity financing will differ depending on the source from which the funds are procured. Equity financing can be obtained from angel investors, venture capitalists, or some crowdfunding portals. IPO issue is also a common means of equity financing for registered private companies.

One of the major benefits of equity financing is that there is no requirement to repay the money obtained through equity. The corporation incurs no additional costs, and there are no obligations of monthly payments, giving the corporation more money to go toward expanding the business. 

Digging deep into the Debt Financing

Debt financing, which is the opposite of equity financing, is raised by the companies by issuing debt securities to investors. Some common debt securities are debentures, convertible notes or warrants. 

In debt financing, money is borrowed in exchange for a fixed rate of interest. A loan taken from banks, NBFCs or under a government scheme is the most typical type of debt financing. Like equity, debt financing comes with its own pros and cons. One major benefit of debt financing is that the lender has no influence on the company, and the relationship with the financier terminates once the interest is repaid. Next, interest payments on debts are tax deductible.

Let us understand this better with the help of an example.

• Example

Company ABC requires the construction of additional facilities and the acquisition of new machinery to grow its operations. It concludes that $50 million must be raised to finance its expansion.

Company ABC determined it would use a combination of debt and equity financing to attain this money. In exchange for $20 million, it offers a private investor a 15% ownership share in its company as part of the equity financing component. It secures a $30 million company loan with a 3% interest rate from a bank for the debt financing portion. Three years are given to repay the debt.

Let us now understand the example mentioned above to produce various results. For instance, if Company ABC only opted for equity financing to obtain money, the owners would have to give up greater ownership, which would have lowered their share of future earnings and decision-making authority. On the other hand, if they were to only utilise debt financing, their monthly expenditures would be greater, leaving them with less money to spend on other things. Additionally, they would have had a heavier debt load to pay back with interest. Therefore, the optimal choice was to combine debt and equity securities. 

Let us now talk about some major differences between debt capital and equity capital:

Difference between debt and equity Financing

Repayment

When using debt financing, one must pay back the borrowed funds plus interest over a certain period of time, usually as monthly instalments. In contrast, there is no requirement for payback in the case of equity-based financing, which frees up additional funds for corporate expansion. 

Ownership

In contrast to debt financing, where one keeps complete ownership, equity investors purchase a stake in the company, reducing the shareholdings of the company’s founders. However, suppose the equity investor offers significant value (in the form of both monetary and non-monetary resources, such as professional advice and access to contacts). In that case, it may be worthwhile to forgo an ownership stake.

Involvement

The involvement of the investors is another major difference between debt and equity securities. Given the different types of equity financing, an angel investor or a venture capitalist firm could request a board seat in return for their investment. This implies that they will participate in business decisions and will have a say in the organisation’s general direction. A lender, on the other hand, is not a shareholder and is not involved in management decisions; they only demand a monetary return on the investments made by them.

Security

In the case of debt financing, the lender may request collateral security, like real estate or machinery, from the borrower. The lender may then seize the asset until they recover their funds. This makes debt financing more secure from the investor’s perspective but risky for businesses. 

However, it is important to note that angel investors and VCs see a relatively low debt-to-equity ratio positively. It is also advantageous to the business should it ever need to secure further debt funding.

Bottom Line:

Debt and equity finance are two major ways for firms to fetch funding. Businesses can either obtain the capital by issuing IPOs or rely on equity or debt investors for their funds. Depending on the company’s objectives, risk tolerance, and control requirements, it needs to choose the one that seems more suitable.