Debt vs Equity Financing: The ins and outs of raising investments

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Published: April 5, 2018 7:30:33 PM

Your early stage startup needs extra capital. Should you go for a business loan or look for an investor and dilute equity? Knowing how to finance your startup is among the most important decisions that can have big consequences. So which one should you go for? Debt investment or equity based funding?

Debt vs Equity Financing: The ins and outs of raising investments

Your early stage startup needs extra capital. Should you go for a business loan or look for an investor and dilute equity? Knowing how to finance your startup is among the most important decisions that can have big consequences. So which one should you go for? Debt investment or equity based funding?

To understand the ins and outs of debt funding and equity based investment, FE Online got in touch with Ashish Sharma, CEO of Innoven Capital.

What’s the best option for early-stage startups?

Most of the times early stage startups mismanage their funds and kill their million dollar idea. “After entrepreneurs have done research, gained insights and built a Minimum Viable Product/Service, they should consider raising Angel funding. This will give the business the ability to hire employees, improve product/service and experiment in the market. If the business is able to establish a product-market fit which addresses a large market and has a disruptive model, doors to institutional equity capital open up and Venture Debt is also available at this stage,” said Ashish Sharma.  

Ownership

With a majority of founders sensitive to diluting equity, it becomes extremely difficult for investors and VCs to negotiate on the same. With debt financing, investors are paid every month as a return for their investment. If everything goes according to the plan, the startup will repay the sum with interest in a pre-decided time-frame.

Talking on the same Ashish stated that in business models that need a lot of capital (like B2C), founders will invariably get diluted with each round. If the business is scaling up as planned, the team will be able to raise subsequent rounds at a higher valuation and optimise dilution. As they say, a smaller piece of a much bigger company is worth more than a bigger piece of a small company.

“In our experience, most founders and their investors are inherently receptive to add some Venture Debt in the company’s capital structure to reduce dilution,” he added

The Risk Factor

The ‘Risk factor’ varies invariably in both Equity and Debt financing with a different risk return profile. “From an investor’s point of view, Equity is higher risk – higher return than Debt. From a company’s standpoint, equity is generally permanent capital and does not need to be paid back. However the company has a contractual obligation to repay the debt over a period of time.”

He further explained that equity investors seek to generate returns thru’ exits via public market, secondary sale or acquisition. On the other hand, Venture Debt providers generate returns through a combination of interest income and potential equity ‘kickers’.  If the company is significantly successful through its lifecycle and has a liquidity event an equity “kicker” allows us to make some additional returns to compensate for the higher risk.

Requirements to Qualify

Debt financing is transactional. You borrow and then you pay back what you owe, while equity gives you access to investor’s knowledge and contacts. Even if they sound poles apart, a few requirements to qualify remains the same. Investors are looking for companies that that fulfill the core market needs giving the platform for the company to sale. Early stage investors have a big appetite for risk (and returns).

“Early stage equity investors have higher risk appetite (and higher return expectations) and therefore willing to come in earlier than Venture Debt. Venture debt financing for start-ups would be available along with or after an institutional equity round. For Venture Debt providers, the liquidity runway of the company and the quality of equity investors are also important,” said Ashish Sharma.

Depleted Funds? Now what

Ashish Sharma stated that If the funds are depleted and business is not viable, there are chances that further equity or debt capital will not be available.” Even if the business has potential at a very high risk, equity based financing will a feasible option.

Choosing the right kind of financing can be a big deal and can have huge impacts on how your business operates. An entrepreneur should never discount combining both, debt and equity financing, according to what they need at that time. Many startups make use of both.

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