Why startups should go for debt AND equity funding

adult-breakfast-breakfast-meeting-1353353As a founder it’s important to understand there are broadly two types of funding: debt and equity financing. Raising equity can speed up the growth of your startup. But most Dutch companies are equity averse. As found in the Financieringsmonitor 2017-2, 93% of all businesses in search of funding were looking for debt. Only 7% of all businesses were open to equity. In this article we zoom in on the debt versus equity dilemma. And find out how Dutch startups prefer to fund their business. 

Equity

Equity financing involves the sale of the company’s shares and giving a portion of the ownership of the company to investors in exchange for cash. Investors will provide equity when they are convinced the chance is high your company value will rise in the future. The proportion of the company that will be sold in an equity financing depends on how much the owner has invested in the company and what that investment is worth at the time of the financing. For example, an entrepreneur who invests €500.000 in the startup of a company will initially own all of the shares of the company.

As the company grows and requires further capital, the entrepreneur may seek outside investors, such as an angel investor or a venture capitalist.  If, in this example, the investor is willing to pay €250.000 and agrees to a share price of €1,00 (i.e. that the original €600.000 invested is still worth €600.000), then the total capital in the company will be raised to €750.000. The entrepreneur will then control 66,67% of the shares of the company, having sold 33,33% of the shares of the company to the investor through an equity financing.

Debt

When a company borrows money to be paid back at a future date with interest it is known as debt financing. It could be in the form of a secured as well as an unsecured loan. A firm typically takes up a loan to finance a building, machinery or stock. Lenders will provide credit when you can explain how you mitigate risks and ensure back payment. 

A company takes on debt financing because it’s often cheaper and less risky than financing all with equity. But too much debt is also risky and thus, companies have to decide a level (debt to equity ratio) which they are comfortable with.

Choosing debt over equity

The biggest advantage for choosing loans is that you maintain control over your business. Unlike equity investors, lenders have no say in your business and are not entitled to your business profits. The only obligation you owe to your lender is to repay the loan as agreed upon. Finally, one last advantage that can be very helpful is that loan payments that go towards paying off the interest on the loan can be deducted as a business expense for tax purposes.

  • Because the lender does not have a claim to equity in the business, debt does not dilute the owner’s ownership interest in the company.
  • A lender is entitled only to repayment of the agreed-upon principal of the loan plus interest, and has no direct claim on future profits of the business. If the company is successful, the owners reap a larger portion of the rewards than they would if they had sold stock in the company to investors in order to finance the growth.
  • Interest on the debt can be deducted on the company’s tax return, lowering the actual cost of the loan to the company.

Choosing equity over debt

Although many may see giving other people an interest in their business as losing control, this doesn’t have to be the case. If you choose the right investors, they can be extremely helpful in terms of running the business, establishing business connections and offering valuable advice and assistance. Another advantage of equity investments over loans is that they tend to be far more creative and flexible, which many businesses may prefer. The single biggest advantage of selling equity stakes to investors is that if your business loses money or goes broke, you likely won’t have to pay investors a dime.

  • Unlike equity, debt must at some point be repaid.
  • The larger a company’s debt-equity ratio, the more risky the company is considered by lenders and investors. Accordingly, a business is limited as to the amount of debt it can carry.
  • Debt instruments often contain restrictions on the company’s activities, preventing management from pursuing alternative financing options and non-core business opportunities.
  • The company is usually required to pledge assets of the company to the lender as collateral, and owners of the company are in some cases required to personally guarantee repayment of the loan.

Debt AND equity

While there are no hard and fast rules, if you are setting up your business, it makes sense to strongly consider equity in order to secure financing to get it off the ground. Equity sales are advantageous because they don’t require any repayment, and most startups don’t turn a profit for a significant time period, which makes paying back loans extremely difficult. If you start getting a steady revenue stream, then loans may make a lot more sense. Loans are easier to deal with when a company has enough cash flow to make repayment realistic, and an established company likely has more collateral to offer to secure the loans. Of course it’s not that black and white. Raising money is expensive and both debt and equity have pros and cons and the truth lies in the middle. Depending on where the money goes for a specific investment you choose debt or equity. All in all it’s the right mix that fuels your startups’ growth. 

The Netherlands Chamber of Commerce is one of the main partners of Amsterdam Capital Week. With a series of blogs I, Martijn Lentz, entrepreneurial finance expert at KVK, share my lessons and pitfalls on how to get funding for your startup.

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