Debt Financing vs Equity Financing for Startups: Pros and Cons
Founders, especially those with no entrepreneurial background, should be cautious and cautious with every move
Evaluate which of the two options (debt financing or equity financing) should be chosen to avoid losses
What are the main differences between debt financing and equity financing?
These are the eternal questions for startups that have moved past growing pains at an early stage and are ready to grow. Among the many options open to Indian startups and their founders, the debate between debt financing and equity financing has been going on for many years.
Ready with a fresh idea and a lot of enthusiasm, beginning entrepreneurs are eager to join the startup game. Most can’t wait to get started, but the truth is that early stage problems often prove fatal for most startups. Founders – especially those with no previous entrepreneurial experience – need to be cautious and cautious with every move they make, because at an early stage most aspects of the business are crucial to securing funding.
Startups can’t just rely on uniqueness of idea or hard work, the influx of funds is also directly related to the likelihood of success or failure. And nowadays, as the Indian startup ecosystem has matured, there are plenty of opportunities for startups to get started. From seed to seed funds through angel investments, start-ups 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 usually results in the startup selling a stake or capital. In the long term, having several CR funding the rounds will hold the business in good stead, but it also takes away the founder’s autonomy.
So in other cases entrepreneurs and founders may resort to debt financing, which is considerably less risky for the investor but adds more pressure on the founder and startup than equity financing. This is because the founders have to repay the debt, which puts pressure on the company’s income.
It is therefore clear that startups need to assess which of the two options – debt financing vs equity financing – should be chosen to avoid losses, undue pressure or hassle in the future. Here’s what distinguishes equity financing from debt financing.
Debt financing vs equity financing
To understand the differences between debt financing and equity financing, you need to know and analyze what these things are. Equity financing takes place when an investor or venture capitalist invests funds in a startup, with the aim of recouping a multiplied amount of the investment made as a return. In this case, the startup does not need to repay the invested funds to the investor but must instead part with part of the shares of the company and return it to the investor. This part of the business is called equity, thus naming this process of financing equity financing.
In debt financing, the investor or venture capitalist essentially lends money to the entrepreneur, against an interest rate, for a period of time, with the assets of the business as collateral. Here, to borrow the fund, the founder sells corporate bonds that act as a loan certificate. There is no question for the investor to acquire shares of the company, but the startup must repay the borrowed amount as well as the interest at predetermined rates. Investors also ask for a company or entrepreneur’s assets as collateral for the loan repayment and could very well offer some debt financing terms.
Based on the definitions, it is easy to understand the differences between debt financing and equity financing. Firstly, while in equity financing, there is no repayment component of the amount, which puts less pressure on the startup for revenue, but puts additional pressure from investors for growth. and future income. Debt financing requires that the invested funds be repaid within a certain time frame, which puts a lot of pressure on the startup’s income and is usually chosen by companies that have a constant inflow of income, such as technology companies from loan, which receive repayments from customers. monthly, part of which can be used to pay off debt.
Another thing to consider is that debt financing does not give the investor any rights in terms of demand for income or returns as long as the debt is properly repaid. But since equity financing allows the investor to acquire shares of the company, he becomes a member of the board of directors and has a say in the business decisions and strategies of the company.
Third, in debt financing, loan default, business closure, or business bankruptcy, the investor can recover the money by foreclosing on the start-up assets held as collateral, and in this case, the investor is one of the first debtors to recover. the funds invested. But such insurance does not exist in the case of equity financing, thus forcing the investor to intervene in business decisions to secure his returns. In the context of equity financing, due to the structure of VC funds, the VC investor in a startup is usually the last to get the returns after paying back the fund’s sponsors.
Finally, to cover or compensate for losses, debt financing allows investors to lend funds at a high interest rate, because investing in startups is a risky business given the high failure rate. Investors in equity funds, on the other hand, dictate terms and have a say in business decisions to ensure high returns in the form of dividends on company earnings. In the event of losses, they must cover it with income from other investments in its portfolio.
Equity or Debt Financing: Duration, Profits and Repayment
In debt financing versus equity financing, the equity path is intended for the different stages of the startup’s journey. In the early years, funds are provided to help businesses grow in terms of productivity, business development, meet customer demands, and start generating profits. Subsequently, the funds are intended to broaden the market base, obtain new customers and cover higher demands, thereby achieving a higher profit margin. In later stages, funds are targeted on scaling up an already successful start-up, through product diversification, expansion into new markets, and meeting business goals such as the introduction on the stock market, mergers with larger companies or acquisitions, which lead to a successful exit of the investor.
Meanwhile, debt funds have no specified milestones and can be raised at any time of the business, depending on monetary need. The use of debt financing varies in terms of requirements such as the investment costs incurred for the establishment, infrastructure, equipment or additional capital requirements for growth, expansion or diversification. , as well as recurring costs such as salaries, rents or maintenance.
When comparing equity funds to debt funds, terms are generally longer for equity funds, while debt funds are categorized into short term and long term. Long-term debt funds are raised for investment costs which have high interest rates and have company assets as collateral. While short term funds are used in recurring payments, have lower interest rates and minimum collateral requirements. In addition, equity funds take away decision-making autonomy from the entrepreneur, while debt funds give them the freedom to define their start-up in their own way.
Challenges of Debt and Equity Financing
Understanding the debate between debt financing and equity financing is of utmost importance for an entrepreneur new to their startup. While startups generally have a higher probability of failure, the founder’s inexperience can also lead to poor business decisions and losses. In this case, equity and debt funds in their own way become a major concern. So, comparing an equity fund with a debt fund is the only way to help the entrepreneur determine which one is best for their job and can ensure success. One needs to carefully consider whether it is comfortable to part with company actions and autonomy from business decisions, and raise equity or obtain debt funds, which must be paid off at all costs.
Another big challenge is entrepreneurship for the first time in the case of startups. This therefore makes it very difficult to raise any type of financing, whether it is equity or debt, because the investor fears losses due to the inexperience of the entrepreneur. To ensure returns for equity financing and on-time debt repayment, investors tend to prefer experienced business owners over inexperienced entrepreneurs. The key factor therefore remains the power of the business idea.