Financing your business: Debt vs Equity

VentureBeat wrote a post recently on debt versus equity which one is right for your business.

This is an important topic for any business. However, I found the VentureBeat article to be too simplistic. The advice given was often conflicting and was specific to their individual situation and context

So what I would like to do here is layout a more comprehensive framework for the pros and cons of debt versus equity and when you could look at each for financing your business.

Debt

At the highest level debt is simply an obligation to repay someone at some future point in time. It can take the form of credit from suppliers, credit cards, unsecured and secured loans, leasing arrangements and other types of repayment obligations.

Clearly, at the start your business has little capacity to repay debt of any kind. Therefore, this is often not the starting point for financing your business.

Equity

Equity is pretty straightforward. You’re giving up a chunk of your business in exchange for cash. Like debt, it can take several forms from common shares (the shares that you most often have as founders), preferred shares, options,warrants and any other instrument that can be converted into equity.

Deciding how to finance

When deciding how to finance your business you must first start with your individual goals.

Why did you start your company?

What role does this business play in your life?

What does “success” mean to you?

This last question is particularly important for your investors because it is the basis for forming alignment. Your goals should be in line with your investors goals or your lender’s goals.

If, for example, you wish to build a “lifestyle” business don’t decide to try to raise venture capital. If you are building a business that you want to run for your the rest of your life then control may be particularly important to you. If this is the case, then you should be very careful about bringing on equity partners because you’re stuck with them forever. They will be looking for some form of exit which usually comes in the form of selling their shares.

Funding lifecycle

In my experience most startups go to a similar lifecycle of financing the businesses:

Personal/sweat equity: in the beginning you only have yourself and you only have an idea. The best businesses are often started with self funding or no funding at all.

Family/friends: next before you truly have an idea of what you have in your hands and how big it can be family and friends can contribute small amounts of cash.

Grants and support programs: many government and nongovernment organizations offer various forms of support programs. These may be repayable loans or forgivable grants.

Once the business has some minor operating history, a business plan and some minimal amount of capital that’s often all it takes to qualify for these programs. These programs can play great role in giving you added runway and more time to prove your business and decide whether you are ready to bring nonequity partners.

Angels: from here, many startups raise some angel capital. Angel rounds come in all shapes and sizes from common shares to preferred shares to convertible notes.

Bank debt and leases: with some outside equity your business can now qualify for bank debt. Usually this starts with a company credit card. Then perhaps a line of credit against securable assets (such as Accounts Receivable or inventory ) and then can expand from there to leases. Often these first loans are fully secured. i.e. you give a $10K deposit to get a $10K company credit card. But it is important to begin building a credit history for your business.

Leases are simply deferred payment plans on equipment. They can be offered by banks, the companies that you buy equipment from or other third parties. They’re less common these days now that everything is cloud-based but depending on whether you roll your own infrastructure or have other capital equipment needs they can be an important source of financing.

SRED funding: Specialized lenders exist to finance tax credits and are other secured receivables. In Canada especially, tax credits can be big $ and getting an advance on them can make a big impact on your business.

Venture Capital: with some angel financing in place and having tapped out available credit, if your business is still growing beyond the ability of your cash flows to support that growth then it maybe time to raise venture capital.

This example is very different from when most businesses look to raise VC. Most go out with an idea or prototype very little traction very little history. This is one major reason why most startups have a really hard time raising venture capital. Venture capital is about acceleration of an existing business not creation for the most part.

The exception of course are seed and micro venture funds who behave in many respects like angels and are very comfortable getting on board at the creation stage.

Venture debt: when a business is maturing and is trending towards cash flow positive, you and your investors may choose to look at venture debt as a way to postpone or completely avoid the need to raise additional capital.

Venture debt is offered by banks and other financial institutions that understand the risks of financing startups. It is offered to startups that are not yet cash flow positive. For this reason it offers meaningful credit at a time when banks are not comfortable offering that credit to startups.

Venture debt is often expensive but can be significantly less expensive than raising additional equity.

Bank debt: Finally, once a business gets to cashflow positive it can start to access meaningful credit from traditional banks.

Making the hard choices

With this framework in mind, how do you decide on the financing mix that’s right for you? As mentioned before, it starts with your personal goals. From there, as your business grows you need to decide what is most important: growth vs. profitability. If you are after growth, then you need to invest in building your team and customer base. This will lead you down the angel and VC path since they are less concerned with profits.

If profit is important to you, then you postpone investing in growth. This does not mean your business does not grow. It just means it grows slower than it would with outside capital.

Growth vs. profits and debt vs equity are not mutually exclusive choices. I know a very successful angel and VC-backed founder who brought his business to cashflow positive each time he was raising outside capital. He did this to give him leverage and flexibility in choosing his financing partners. A smart strategy if you can pull it off.

Finally, while angels and VCs have similar goals they differ in terms of tolerance for losses and thus capital requirements. In my experience, angels are most comfortable with one or two equity rounds after which they expect the businesses to sell or become cashflow positive.

VCs are only concerned with proving the business model and per customer economics. If they have a profitable business model, then they will happily fund growth and postpone losses as long as the business keeps growing.