Breedlove's Briefing: The Difference Between Debt and Equity Financing

November 12 - Stephanie Breedlove

Hi! I’m Stephanie Breedlove, Co-Founder of HomePay, Author and Angel Investor.

I absolutely adore taking an idea and giving it life in the form a business, then leading it to its full potential. Nothing is more fun. (Seriously!) I’d love for every woman who wants to start her own business to say the same thing, so here I am, mentoring millennial entrepreneurs. When I’m not working, I like to recharge and head outdoors to hike, bike, or stand up paddle board!

Is that list of business news and trending articles you’ve tagged still unread? I get it. Allow me to help. Take a couple minutes to read my summary of articles serving the most pertinent, actionable business topics. Or, take 10 minutes to read the full article, and put another brick on the foundation of your growing career.

This Week’s Must-Read:

Debt vs. Equity Financing: Pros and Cons for Entrepreneurs

Who it’s for:

Every entrepreneur. How we fund our businesses is often the key factor for a successful start or for the ability to scale.

Why it’s important:

Yes, I’m writing about funding once again, because it is soooo important. Get educated and comfortable with the financial aspects of your business and experience huge wins! This is one of the best ‘Financing 101’ articles I’ve read. It will jump-start a quality process for choosing the best funding option for you and your company.

Contrary to popular belief, equity funding is not the only way to breathe financial capital into your business. It is vital for entrepreneurs not to blindly follow the herd just “because everyone else is doing it.” You should also consider debt financing as the preferred option. Which one is right for you? Here’s the summary:

Debt Financing: We’re all familiar with debt. Debt means you are borrowing, much like that student loan or car loan. You usually have monthly installments over a period of time with a predetermined interest rate. The biggest advantage of using debt versus equity is control and ownership. It’s all yours with debt: You make all the decisions and keep all the profits.

An often overlooked advantage of debt is that it can create more tax deductions. The most significant danger is that it requires repayment, no matter how well you are doing, or not. Structures used by early stage startups are convertible notes, SAFEs, and venture debt. These forms of debt eventually convert into equity on a subsequent financing round, so they can be good ways to bring on people that may partner with you for the long run.

  1. Convertible Notes: Convertible notes are a debt instrument that also give the investor stock options. This flexibility gives them security from the downside, and more potential upside if the start-up performs well. Convertible notes are much faster than equity rounds. There are 3 main ingredients the entrepreneur needs to look after with convertible notes:
  2. The interest that the entrepreneur is giving to the investor. This interest accrues on a yearly basis on the investment amount the investor puts into the company.
  3. The discount on the valuation. This means that if your next round is at X amount of pre-money valuation, the investor will convert her debt at a discount from this valuation.
  4. The valuation cap. This means that regardless of the amount that is established on the valuation in the next round, the investor will never convert north of whatever valuation cap is agreed upon.

Equity Financing: This type of funding exchanges incoming capital for ownership rights in your business. This may be in the form of close partnerships, or equity fundraising from angel investors, crowdfunding platforms, venture capital firms, and eventually the public in the form of an IPO. There are no fixed repayments to be made. Instead, your equity investors receive a percentage of the profits, according to their stock.

An advantage of equity financing is that it has the potential to bring in far more cash than debt alone. It often provides the ability to launch and to scale to full potential. Far more important than the money is that bringing in equity partners means bringing in others with a vested interest in seeing you succeed. The primary fear of giving up equity is loss of control, which can affect every micro-factor in your business. It’s also important to know that equity fundraising can be arduous and time consuming, and can easily distract you from running your business.

Top Take-Away/Final Thought: There are advantages and disadvantages of both debt and equity fundraising. Take the time to learn and understand the pros and cons before you start searching for the money. This will allow you to smartly determine which may be the most beneficial for your current stage of business, and how it could help or hurt for future fundraising needs. Knowledge is power for good decision making!

SAFE: A newer instrument created by Y Combinator which has been adopted by many early stage companies. The Simple Agreement for Future Equity (SAFE) aims to increase simplicity while preserving flexibility. Y Combinator argues that these notes do not accrue interest or have maturity dates, which makes them friendlier to entrepreneurs. A SAFE automatically converts to preferred stock at the next equity round of funding.

Venture Debt: Venture debt is effectively borrowing to raise working capital and growth capital. This is a valuable source of funding that doesn’t mean giving up more ownership or diluting equity. Venture debt financing differs from other sources of money in that it is normally provided by specialist entities and banks, such as Silicon Valley Bank, that offer their services to funded start-ups and growing businesses. They understand the dynamics of a start-up and will often lend even though asset collateral may be weak.

Want a deeper dive on fundraising? Check out these related articles:

10 Ways First-Time Entrepreneurs Can Better Their Startup’s Chances at Fundraising

5 Fundraising Tips for Female Entrepreneurs

How Startup Funding Works

A Beginner’s Guide to Funding a Startup

A Definitive Guide to Debt Financing for Small Businesses

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