Equity or Debt: Questions Entrepreneurs Should Ask

This is another awesome Guest blog post from Andre Averbug.

In a previous post, I covered the kinds of investors that support startups. In the last post, I discussed the different types of financial instruments available to startups. But how does an entrepreneur know which type of instrument is ideal for his or her business? Let’s now turn to the main questions one should ask when trying to decide between the two key instruments – equity and debt.

Whether raising capital through equity is right for you depends on how you answer the following questions:

  • Does your business have the potential to grow exponentially? Equity investors, such as angels and VC funds, will only buy equity in startups, i.e., companies that are working on scalable solutions and have the potential to increase the value of that equity substantially over the next several years. In other words, they will not invest in lifestyle businesses, which are businesses that may be successful and last decades, but without experiencing fast growth and giving investors an exit opportunity. Equity investors get their return when they sell their equity (exit) at a higher valuation to new investors, either private, such as a private equity (PE) fund or, if they are very lucky, through an initial public offering (IPO). Therefore, be realistic and ask yourself: Is my business a startup or a lifestyle business? By the way, there is nothing wrong with being a lifestyle business, and a friend or an uncle might even put some equity in it. However, professional equity investors will only invest in true startups.
  • How important is it for you to retain ownership? Some entrepreneurs are overly protective of their equity and want to maintain full ownership at all costs. This is usually not a good mindset, especially if you run a startup, given that sharing ownership with investors, management, and even staff might be key to the success of the business. You will need investors to help grow your business and more partners to align interests and have everyone onboard and working for the long-term success of the company. Remember, it is better to have smaller share of a highly successful business than 100% of nothing. So, if you feel you are the overly protective type, consider rethinking your approach – otherwise, equity may not be for you.
  • Do you work well with others and welcome mentorship and opinions? When you get equity partners you are embarking in a relationship that you don’t know how long is going to last and how smooth (or rough) it will be. Angels and VCs, particularly, will want to participate in key business decisions and often mentor you. They will likely want a seat at the Board. To maximize the chances of success for this relationship, be sure you can take opinions, you welcome feedback (constructive and sometimes not so much), and that you can share some of the decision making. Remember these investors are literally betting on you. They are putting money in the early stages of your venture, when risks are extremely high, and deserve – in fact, usually have the right – to have their voices heard. It doesn’t mean that they are always right and that you should avoid disagreements. Simply be open to healthy discussions.
  • How much support do you need, on top of the money? Equity investors usually bring a lot more than just money. They help you with corporate strategy and business development, open doors through their Rolodexes, provide industry knowledge, sit on your side of the table in major negotiations, such as sales, partnerships etc. If none of that seems important to you (really?!) and you strongly believe in your ability to grow the business on your own or with your current team, then perhaps taking a loan – if you can – would be the best approach. That is because, if your business is indeed successful, it means your equity will gain value over the years, and the cost of selling equity should be higher than taking debt.

When it comes to debt, these are some of the important questions to ask:

  • What is your current (and future) cash flow situation (projection)? You should not take a loan if you are not confident in your ability to commit to debt repayments, including interest and principal. If you are in the earlier stages of your company, have not broken-even yet, and don’t see it happening in the near future, perhaps debt is not for you. Debt requires some degree of predictability in your financial situation to ensure you can service it accordingly. For that reason, it is not a very popular instrument for early-stage startups (unless when offered in hybrid instruments such as convertibles), being more suited for later-stage companies and lifestyle businesses.
  • Do you have collateral (assets), credit history, or receivables? Banks and other lenders may still give you a loan if you don’t have enough cash flows. However, they are notoriously risk averse and will only provide you with a loan if they are comfortable with their ability to recover their loan, even if it means acquiring your assets to cover or minimize their loss. Therefore, even if you think debt is the right instrument for you, if you don’t have enough revenues, promising receivables, a credit history, or some collateral (machinery, building, inventory etc.) to borrow against, chances are you will not be able to get that credit.
  • Are you comfortable using collateral, including personal assets? When it comes to collateral, the question is actually deeper: It is not just whether you have it or not, but also if you are willing to borrow against it. Some entrepreneurs believe so much in their business that they literally bet their car or house on it! Even when the company itself does not have assets, the entrepreneur uses his or her own property as collateral providing personal guarantees to the bank. This is certainly not for the fainthearted and doesn’t make sense for everybody. Also, tragically, sometimes entrepreneurs expose personal assets without knowledge. Be sure to check the laws and regulations in your country to see whether your company provides you with limited liability or if creditors could go after your personal assets in case of debt default.

While this list of questions is certainly not exhaustive, it covers some of the key issues I had to ask myself during my fundraising experiences. If you have more ideas for questions, feel free to share them in the comments below!

 

Andre portrait

Andre Averbug is an entrepreneur, economist, and writer. He has over two decades of international experience working in the intersection of economic development, entrepreneurship, and innovation. He has worked and lived in multiple countries across North and South America, Europe, Africa, and Central Asia.

Andre has started and run four startups, in Brazil and the US, and was awarded Global Innovator of the Year in 2009 by World Bank’s infoDev. He has extensive experience supporting companies as mentor and consultant, both independently and as part of incubators such as 1776 and the Kosmos Innovation Center, and programs like Shell LIVEWire, StartUp Weekend and WeXchange.

As an economist, Andre has worked in topics ranging from innovation ecosystems, entrepreneurship and MSME development policy, competitiveness, business climate, infrastructure finance, monitoring and evaluation (M&E), and country assistance strategy for the World Bank, the Inter-American Development Bank (IDB), and the Brazilian Development Bank (BNDES). He has also consulted for clients such as DAI Global, the Economist Intelligence Unit (EIU), TechnoServe, among many others. He holds a master’s degree in economics from the University of London (UK) and an MBA from McGill University (Canada). Andre lives in the Washington, DC area.

He writes an awesome Blog called Entrepreneurship Compass and you can sign up here: https://entrepreneurshipcompass.com

Overview of Financial Instruments for Startup Funding

 

This is another awesome Guest blog post from Andre Averbug.

In a previous post I discussed the different types of investors available to entrepreneurs. But choosing the right investor depends also on the types of financial commitment you are willing to take on. Therefore, in this post I will discuss the main financial instruments used to fund startups – equity, debt, grants, and convertibles – and their pros and cons.

EQUITY

Equity fundraising is when a firm raises capital through the sale of shares in the company. For example, a startup raises $50,000 by selling a 10% ownership to the equity investor (e.g.: angel investorVC fund), representing a post-money valuation for the startup of $500,000. The investor gets the return on the investment through an exit event (e.g.: buyout from another investor at a higher valuation, IPO) and sometimes through dividend payments.

Pros:

– No obligation to pay back:  The equity investor becomes a partner and takes on the risk of the business. Differently from debt, you have no obligation to pay back. An equity investment, therefore, capitalizes your firm without limiting your future cash flow.

– Accessibility: Equity investors do not expect you to necessarily have revenues, creditworthiness, or collateral. They are betting on you and your business venture and their dollars should be accessible as long as you have an attractive and solid business proposition. For this reason, equity is often the ideal type of investment instrument for startups.

– Interests aligned: Because these investors become partners, their interests overall are aligned with yours. All parties want to see the business prosper in the medium to long term, differently from creditors, who might only be interested in your ability to pay back the debt regardless of the broader success of the business.

– Non-monetary support: Because incentives are aligned, equity investors often bring a lot more than money to the table. They may help you with mentoring, moral support, connections in the industry, introductions to strategic partners, and pulling in more investors in the future.

– Signaling: Receiving equity investment, especially from institutional investors such as VC funds, serves as seal of approval. It signals to the market that your business has been validated by a professional (and demanding) player. This brings status and opens doors when it comes to sales, negotiations, contracts, and further fundraising.

Cons:

– Loss of control: When you sell shares of your company you are also giving away part of your control. The extent varies according to how much the shares sold represent of the total equity, but first-round investors might typically ask for anywhere between 10-30% ownership. This normally comes with a sit at the Board and the right to participate in key business decisions.

– Share success: Well, this is more of a reminder than a “con” per se, but obviously, the more partners you have the more you will have to share the profits of the business and returns from a potential exit. This is normally not a problem, though, because hopefully investors help you “grow the pie”. As the saying goes, “it’s better to have 20% of the Empire State building than 80% of an old shack” (or maybe I just made this up?)

– Binding relationship: Equity investment is similar to a marriage. When entrepreneurs and investors become partners, they are tied in an open-ended relationship. The investors do want to exit at some point but, differently from a loan, which has clear terms and an end date, one never knows how long and how rough the partnership ride will be. If all goes well, this shouldn’t be a problem. But if the relationship becomes difficult, which is not uncommon given all the risks and stress involved, it can turn into a debilitating factor to the business.

DEBT

Debt is when a firm takes a loan from a backer (e.g.: bank, person, government institution) with the obligation of repaying principal and interest in a defined schedule. For example, a startup might take on a $50,000 loan from a commercial bank, at 10% annual interest to be paid monthly, with principal (i.e., the original $50,000 borrowed) to be repaid in 2 years, after a 6-month grace period (i.e., no interest payment is due in the first 6 months).

Pros:

– Ownership: With a loan you are not giving shares of your company to the creditors, you are simply borrowing money. This means that, differently from equity investors, creditors do not become your partners, do not dilute your ownership, and will not have a saying in how you run your business – you keep the control.

– Predictability: When you take a loan, you know all the terms of the relationship in advance. For example, you will have to pay X dollars every month, for 24 months, and then repay the principal after that. After repayment, the relationship with the lender ends. This makes it straightforward to incorporate the liability into your cash-flow plan and the broader corporate strategy and goals, without major uncertainties.

– Discipline: The obligation to pay back debt tends to make entrepreneurs more careful with the way they manage their resources. When you know you need to honor monthly payments and return the amount borrowed at the end of the period, you become more careful with the way you handle your expenses, procure suppliers, manage your costs, and go after your goals more broadly. This often brings positive lasting results in terms of financial management and corporate strategy.

– Cost: If your startup is successful, and the terms of the loan are aligned with market rates, debt is probably cheaper for you than selling equity. The value of early-stage startup shares can increase multiple-fold over just a couple of years. Therefore, if you believe in your startup and manage to get a loan instead of selling stocks, this will likely (hopefully!) cost less than selling equity prematurely.

Cons:

– Accessibility: Banks and other lenders are notoriously risk averse. This means that they will only lend to companies that can prove they can pay back. This is often a challenge for startups, which may not have steady revenues yet, little or no collateral to guarantee the loan, and limited receivables. Therefore, even if this seems like the best option, it might be hard to get.

– Obligation: With a loan, you either honor your payments “or else”… Depending on the laws of the country and what you used as guarantee, if you fail to pay back you may end up having issues liquidating the business, facing legal consequences, or even losing personal assets such as your house. The lender, differently from the equity investor, is not willing to share the risk of the business with you. Therefore, you must feel confident that you will be able to pay back the loan and understand the legal consequences before embracing this commitment.

– Discipline: The same discipline that can be an advantage can also be a limiting factor. For a startup, depending on how the business goes, servicing a loan monthly can mean that you need to tighten up your budget, cut your expenses, and even reduce investments to ensure you honor your obligations.

GRANTS

A grant is when a firm gets funds, normally to be used in particular functions, without the obligation to pay back or give shares of the company in exchange. For example, a company is awarded a $50,000 government grant as part of a program to support innovation and R&D. The startup’s only obligation is to use the funds as agreed and report on its progress.

Pros:

– Ownership and no obligation to pay back: A grant offers the best of both worlds in terms of the advantages of equity and debt. You don’t have to pay back and you don’t give away any control. Simply put, grant is free money!

– Accessibility: If a grant targets startups, much like equity, it usually does not require the company to prove creditworthiness, to have revenues, or collateral. It should be accessible to most startups that fit the profile the grant is meant to support.

– Signaling: Much like equity, receiving a grant also serves as seal of approval. Grants have highly competitive processes (who doesn’t want free money!) and winners are often praised publicly and receive good publicity. Winning a grant also places you favorably to win future ones from the same or complementary funders, as donors want to see you succeed to justify their programs.

Cons:

– Competitive: As mentioned, a grant attracts a lot of attention and normally gets thousands of applications. It is usually not something you can count on winning and incorporate into your business planning. At the end of the day, depending on the market, it might easier (or at least more predictable) to raise equity or get a loan. The grant would be seen as the icing on the cake.

– Time consuming: Well, nothing is really free. Applying for grants is very time consuming as the application processes are usually lengthy and bureaucratic. It requires a lot of time and focus and therefore it has a high opportunity cost. Also, if you win, usually there are thorough reporting commitments and you need to produce detailed periodic reports and show how every penny has been spent.

– Strings attached: Grant money is usually earmarked to certain types of investments or expenses. Therefore, you may not be able to spend the money as you wish. For example, even if you land a large grant of say $500,000, if it is part of an R&D program, you may not be able to spend a penny of it on what you might need the most at the time, say payroll or marketing and sales.

CONVERTIBLES

A convertible note (or debt, or bond) is a hybrid instrument, with debt and equity features. The firm borrows money from an investor (e.g.: angel investor, seed fund) and the intention of both parties is to convert the debt to equity at a later date. Typically, the note will be converted into equity in the subsequent round of equity investment, at a discounted valuation. For example, a company raises $50,000 in convertible debt, for 2 years, annual interest rate of 5%, and a 20% conversion discount. If a new round of investment (e.g.: VC fund) occurs within 2 years and shares are valued at $1, the convertible investor will purchase them for $0.80, buying 62,500 shares instead of 50,000. However, if after 2 years no new investment is made, the company needs to repay investors the $50,000.

Pros:

– Fairness: Convertibles solve a major problem in early-stage funding: valuation. It is very hard to come up with a sensible valuation for early-stage startups, especially those in ideation and pre-revenue stages. Convertibles solve this problem by pushing the valuation conversation forward in time, for only when/if the business is more developed and a professional investor is able to make a more educated assessment.

– Win-win: This is a financial instrument both entrepreneurs and investors are quite comfortable with, especially given the fairness argument above. Entrepreneurs are not giving out equity sooner than needed and investors are not running the full equity risk.

– Most equity pros: Most equity pros discussed above – except, before conversion, for the “no obligation to pay back” – apply here.

– Some debt pros: The debt pros of “predictability” and “discipline” also apply here.

Cons:

– “Worst” of both worlds: While grants get you the best of both worlds of equity and debt, convertibles, in a way, may get you the worst. This is because, if the business is being successful and you raise more funding, you will be selling your valued equity at a discounted rate. Alternatively, if the business is not going well, or even fails completely, you will still need to pay the investor back. The former scenario is certainly less of an issue because the investor surely deserves the discounted valuation for having backed you early in the process. But the latter might put you in the “or else” situation discussed above for debt, exactly in a moment your company might not be doing well.

– Equity cons: All equity cons apply here in case the note converts.

– Debt cons: All debt cons apply here, except for what regards principal repayment in case the note converts to equity.

Choosing the right financing instrument is a key strategic decision for any startup. Stay tuned because, in the next post, I will discuss the main questions entrepreneurs need to ask themselves when it comes to making this decision.

 

 

Andre portrait

Andre Averbug is an entrepreneur, economist, and writer. He has over two decades of international experience working in the intersection of economic development, entrepreneurship, and innovation. He has worked and lived in multiple countries across North and South America, Europe, Africa, and Central Asia.

Andre has started and run four startups, in Brazil and the US, and was awarded Global Innovator of the Year in 2009 by World Bank’s infoDev. He has extensive experience supporting companies as mentor and consultant, both independently and as part of incubators such as 1776 and the Kosmos Innovation Center, and programs like Shell LIVEWire, StartUp Weekend and WeXchange.

As an economist, Andre has worked in topics ranging from innovation ecosystems, entrepreneurship and MSME development policy, competitiveness, business climate, infrastructure finance, monitoring and evaluation (M&E), and country assistance strategy for the World Bank, the Inter-American Development Bank (IDB), and the Brazilian Development Bank (BNDES). He has also consulted for clients such as DAI Global, the Economist Intelligence Unit (EIU), TechnoServe, among many others. He holds a master’s degree in economics from the University of London (UK) and an MBA from McGill University (Canada). Andre lives in the Washington, DC area.

He writes an awesome Blog called Entrepreneurship Compass and you can sign up here: https://entrepreneurshipcompass.com