Entrepreneurship Industry News

Debt Funding Vs Equity Funding For Startups: Pros And Cons

  • Founders, especially those with no previous entrepreneurial experience, need to be wary and cautious with each move
  • Evaluate which of the two options — debt funding or equity funding — should be chosen to avoid losses
  • Wha are the major differences between debt funding and equity financing?

It’s the eternal questions for startups that have progressed past the early-stage growth pains and are ready for expansion. Among the many options available for Indian startups and their founders, the debate of debt funding vs equity funding has been going on for many years.

Ready with a fresh idea and a lot of enthusiasm, first-time entrepreneurs are eager to join the startup game. Most can’t wait to get running, but the truth is that troubles in the initial phase often prove fatal for most startups. Founders — especially those with no previous entrepreneurial experience — need to be wary and cautious with each move they make, as at an early stage most aspects of the business are crucial in securing funding.

Startups cannot simply rest on the uniqueness of idea or the hard work being put in, the inflow of funds is directly linked to the probability of success or failure as well. And these days as the Indian startup ecosystem has matured, startups have plenty of avenues to get started. From bootstrapping to seed funds to angel investments, early-stage startups have a plethora of options.

But when the need of the hour is big funding, startups usually have to turn to VCs or institutional investors, which typically results in some stake or equity being sold by the startup. In the long run, having multiple VC funding rounds will hold the business in good stead, but it also takes away the autonomy of the founder.

So in some other cases, entrepreneurs and founders may resort to debt funding which is considerably less risky for the investor but adds more pressure on the founder and startup than equity financing. That’s because founders have to pay back the debt and this puts revenue pressure on the company.

So clearly, startups need to evaluate which of the two options — debt funding vs equity funding — should be chosen to avoid losses, undue pressure or hassles in future.  Here’s what sets equity funding apart from debt funding.

Debt Funding Vs Equity Funding

To understand the differences in debt vs equity financing, one needs to know and analyze what these things are. Equity financing takes place when an investor or a venture capital firm invests funds in a startup, with a motive of earning back a multiplied amount of the investment made in the form of returns. In this case, the startup doesn’t need to pay back the fund invested to the investor but instead has to part with a chunk of company shares and give it to the investor. This company share is called equity, thus naming this funding process equity financing.

In case of debt financing, the investor or venture capital firm basically lends money to the entrepreneur, against a rate of interest, for a given period, with company assets as securities. Here, to borrow the fund, the founder sells company bonds which acts as a certificate of loan. There is no question of the investor acquiring company shares, but the startup has to repay the amount borrowed along with the interest at predetermined rates. Investors also ask for a company or the entrepreneur’s assets as security for the loan repayment and might well put forward certain terms and conditions for debt financing.

Going by the definitions, it’s easy to understand the differences in debt funding vs equity funding. Firstly, while in equity financing there is no component of repayment of amount, which puts less pressure on the startup for revenue, but does bring in added pressure from investors for growth and future revenue. Debt financing requires the invested funds to be repaid within a certain period, so this brings a lot of revenue pressure on the startup and is usually opted by those businesses which have a steady inflow of revenue such as lending tech companies, which get repayments from customers on a monthly basis, part of which can be used to pay back the debt.

Another thing to consider is that debt financing gives the investor no rights in terms of demanding revenue or returns as long as the debt is being repaid duly. But since equity financing lets the investor acquire company shares, they become part of the board of directors and have a say in business decisions and company strategies.

Thirdly, in debt financing, non-repayment of the loan, company closure or business failure, the investor can get back the money by seizing startup assets kept as security, and in this case, the investor is one of the first debtors to get back the funds invested. But there is no such assurance in case of equity financing, thus making the investor intervene in business decisions to secure their returns. In the context of equity funding, due to the structure of VC funds, the VC investor in a startup usually is the last to get the returns after it has paid off the limited partners in the fund.

Lastly, to cover up or compensate losses, debt funding enables investors to lend funds at a high-interest rate, as investing in startups is a risky affair given the high failure rate. Equity fund investors, on the other hand, dictate terms and have a say in business decisions to ensure high returns as dividends of the company profit. In case of losses, they have to cover it up by earnings from other investments in its portfolio.

Equity Vs Debt Funding: Tenure, Profits, And Repayment

The funds for startup differ in terms of usage, tenures, and nature making it easy to trace the comparison of equity vs debt funds. Let us now point them out one by one.

In debt funding vs equity funding, the equity route is meant for different stages of the startup’s journey. In the initial years, the funds are provided to help companies grow in terms of productivity, business development, meet customer demands and start earning a profit. Thereafter funds are meant for widening the market base, get new customers and cover higher demands, thereby registering a higher profit margin. At the later stages, the funds are targeted towards upscaling of an already successful startup, through diversification of product, expansion to new markets and achievement of business goals such as IPO, merger with bigger companies or acquisitions, that lead to a successful exit of the investor.

Meanwhile, debt funds have no specified stages and can be raised at any point in the business, depending on the monetary needs. Usage of debt funding varies in terms of requirements such as capital costs incurred in setting up, infrastructure, equipment or additional capital requirement for growth, expansion or diversification, as well as recurring costs like salaries, rents or maintenance.

In comparing equity fund vs debt funds, tenures are usually longer for equity funds, while debt funds are categorized into short term and long term. Long term debt funds are raised for capital costs which have high-interest rates, and have company assets as collateral. Whereas short term funds are utilized in recurring payments, have lower interest rates and minimal collateral requirements. Moreover, equity funds take away the autonomy of decisions from the entrepreneur while debt funds let them have freedom of strategizing their startup in their own way.

Challenges In Debt And Equity Funding

Understanding the debate of debt funding vs equity funding is of immense importance for a first-time entrepreneur in his startup. While startups generally have a higher probability of failing, the inexperience of the founder can also lead to wrong business decisions and losses. In this case, both equity and debt funds become a huge concern in their own way. So, comparing equity fund vs debt fund is the only way that would help the entrepreneur assess, which one is the best fit at his position and can assure success. One has to carefully consider if he is comfortable in parting with company shares and autonomy of business decisions, and raise equity fund or get a debt fund, which has to be repaid at any cost.

Another big challenge is first-time entrepreneurship in the case of startups. It, thus, makes it very difficult to raise any kind of funding, be it equity or debt, as the investor fears losses due to inexperience of the entrepreneur. To ensure returns in case of equity funding and on-time repayment of debts, investors tend to prefer experienced business owners instead of inexperienced entrepreneurs. The key factor, therefore, remains the power of the business idea.

Read More: Inc42