Many startup founders do not have a clear understanding on when to go for borrowing (also called as debt or loan) or when to seek equity investment (that is by selling a portion of the company’s ownership and its future profits).
Many founders tend to prefer Equity assuming that Equity investment comes without any problem or Debt should be avoided at any cost. In truth both these assumptions are not right. There are times when Equity would be a better choice . Under certain conditions, Debt is favorable to the founders’ long term interest, if they are able to plan and meet repayment obligations.
This article would give answers to these frequently asked questions:
- When should a startup founder consider debt and when equity investment to meet the financial needs of the company?
- What are the precautions a founder has to take when availing debt and what are the considerations for equity?
When deciding between debt and equity financing, startup founders should carefully consider their specific financial needs, risk tolerance, and growth plans. Both options have their advantages and disadvantages, so understanding the implications of each is crucial. Here’s a breakdown of when to consider debt and equity, along with precautions and considerations for each:
1. Debt Financing (Loan financing):
Debt financing involves borrowing money from lenders, such as banks or private investors, with the obligation to repay the principal amount plus interest over a specified period. Debt can be an attractive option when:
- Short-term financing needs: If the company requires funds for a specific project or to manage temporary cash flow gaps, short-term debt can be an appropriate choice. For instance, a software startup might need to invest in additional servers to handle increased user traffic, and a short-term loan can cover these expenses until revenue catches up.
- Lower risk and control retention: Taking on debt doesn’t dilute the founder’s ownership stake in the company. As long as the company can meet its debt obligations, the lender has no say in business decisions, allowing the founder to maintain full control.
Precautions for Debt Financing:
- Debt Serviceability: Founders should carefully assess the company’s ability to repay the debt. It’s essential to have a solid repayment plan in place and ensure the company’s cash flow can cover both interest payments and principal repayment. When executing regular orders for which payments come in time, for funding working capital, founders should consider debt funding. Cultivating a good relationship with banks and ensuring a good financial track record will help the startup obtain credits quickly and on good terms. Having a record of paying taxes like GST and Income tax etc will enhance the credit rating. And seeking short-term cash credit is also a good idea, as under cash credit, one has to pay only the funds availed. As soon as the payments are received, you can square the account and stop paying interest.
- Interest Rates and Terms: Different lenders offer various interest rates and terms. Founders should compare offers from multiple lenders to secure the most favourable terms for their startup. When signing up for Loan, please check whether you are getting good interest terms such as fixed versus floating interest rate, and clauses like foreclosure and flexibility to repay before schedule etc may have to be checked.
- Risk of Default: Taking on debt carries the risk of default. If the startup faces financial difficulties and cannot meet its repayment obligations, it could lead to severe consequences, including bankruptcy.
- Need for Collateral: Sometimes Banks may insist on Collateral for lending money. It is not entirely bad to give collateral, if you are confident of repayment and your business is healthy. The only thing the borrower must take care of is to avoid borrowing more money than required and deploying them for purposes that are not productive. Usually acquiring some unproductive assets, like buildings or diverting money to acquiring personal assets are typical mistakes founders commit. Cash flow is like blood flow, for the healthy survival of any business cash flow is more important than having assets that may not be useful for the conduct of business.
To avoid this, startups must not borrow beyond a certain limit. Repayment obligations may be missed because inadequate cash flow from business. Usually borrowers tend to take short term loans to fund capital equipment purchase, such as machinery or building new facilities. This will lead to draining of available liquid cash. Instead when funding capital equipment or even product development expenses, the founders must carefully plan and go for medium and long term repayment schedules. These repayment must match the cash flow to be generated by the additional capacity created. This will help the company to maintain liquidity to meet the ongoing needs and the loan can be paid over a period.
You must also remember that Interest is treated as an expense in Profit and Loss, which means, you may gain, if the interest pay-outs are balanced. Selling equity means you not only lose ownership and control of the company, but also share of profit will go to equity investors.
Example: A small e-commerce startup wants to expand its product offerings and needs additional funds to purchase inventory. Instead of giving up equity, the founder decides to take out a short-term loan to finance the inventory purchase. The loan is structured to be repaid within six months, after the busy holiday season when sales are expected to soar.
2. Equity Financing:
Equity financing involves selling shares or ownership stakes in the company to investors in exchange for capital. Equity funding can be a suitable option when:
- Long-term growth plans: If the startup has ambitious expansion plans and needs substantial funds to fuel growth, equity financing may be more appropriate. Investors may be willing to provide the necessary capital in exchange for a share in the company’s future success.
- High-risk ventures: Startups with unproven business models or technologies that carry higher risks might find it challenging to secure debt financing. Equity investors may be more willing to take on these risks, as they have the potential for higher returns if the company succeeds.
Considerations for Equity Financing:
- Dilution of Ownership: Selling equity means giving up a portion of the company to investors. Founders should be aware of the potential loss of control and decision-making power as more investors come on board.
- Investor Relations: Equity financing involves sharing financial information and updates with investors. Founders need to consider the time and effort required to maintain good investor relations.
Example: A biotech startup has developed a groundbreaking medical device that requires extensive clinical trials and regulatory approvals before it can be brought to market. The founders decide to seek equity investment from venture capitalists to fund the lengthy and costly development process.
The decision to opt for debt or equity financing depends on the startup’s specific needs, risk appetite, and growth plans. A combination of both debt and equity financing can also be considered, depending on the circumstances. However, founders must carefully evaluate the potential implications and take necessary precautions to ensure the financial health and success of their startup.
One need not assume that either Debt or Equity has the best option. Instead study the situation and select the best option between the two.
A J Balasubramanian is a serial entrepreneur, with over three decades of startup experience in founding companies, mentoring / incubating startups and writes regularly on topics of interest to startups.
