What’s the difference?
Let’s start by making the distinction between debt and equity. It’s pretty simple. Debt is an obligation, on the part of the company, the entrepreneur, or both. Over a certain period of time, the company is obligated to repay the debt, at a specified interest rate.
Equity financing is the purchase of shares of stock in a company in return for money invested in the company. A company typically has no formal obligation to repay equity. You give your investor a piece of paper called a stock certificate. They give you money. Of course there’s a catch: the investor expects that at some point there will be a liquidation event. This means that at some point your company will be sold or go public. The investors will sell their stock, either to the new owners, or on the public stock exchanges—hopefully at a big profit either way.
So, not only do you need to understand your company’s appetite for financing and the type of financing you need to get where you’re going, you also need to understand that the type of financing you secure will determine your business’ growth direction.
Because equity investors are taking such a risk with no specific obligation of repayment, they are also going to expect—or perhaps demand—that the company take a route that will lead it to fast growth and a significant increase in its value over a relatively short period of time. Debt-holders on the other hand, be they banks or individuals, will pretty much stay out of the affairs of your business, as long as you’re making your loan payments and your periodic financial reports seem to be on target.
Which does your company need?
Types and sources of debt vary widely, from simple loans from friends and family to complicated transactions dreamed up by Wall Street wizards. But it basically comes down to one thing—they give you the money, you pay it back. Of course, the miracle of compound interest is on their side. To feed this miracle, you need cash flow. You need some kind of revenue stream so you can repay the loan. Sometimes a lending source will get creative and give you a grace period during which no payments are required and interest accrues. But a rule of thumb—that certainly has a fair share of real life exceptions—is that a technology company that needs development time, and is expecting to grow rapidly, will neither be able to fulfill debt obligations nor secure enough money in the early stages from debt sources to fuel the company.
Another rule: It’s when you don’t need the money that banks are happy to lend it to you. If your need is great, your ability to pay back probably isn’t so good, and then they’re less likely to lend to you. Technology growth companies typically have a different appetite. They’re hungry for equity.
Some debt and equity pros and cons
Investors share your viewpoint because they take the risk with you. They get their reward when you do—usually when the company is sold or goes public. If you need additional equity to grow, investors often have extensive contacts and can help. Investor cash can help attract top-notch management teams.
Founders give up a percentage of their companies’ ownership. Owners lose some control of their companies, and the outsiders even have a say over the founders’ salary. (Although this is not always bad, as giving up control can help keep you on your toes!) Companies can get into the “more where that came from” syndrome, always looking for investors but never making a profit.
There’s no dilution of ownership; original owners keep it all. As long as the debt payments are made, the original owners give up no operational control. The company turns a profit sooner because owners must make cash to serve the debt and have access to additional credit.
Not all companies have access to debt financing; lenders want collateral in land, equipment, or a patent. If the company doesn’t make payments, it loses everything. Growth is limited to internally generated cash flow, or additional credit based on the company’s profitability. Lenders want equity and convertible debt dilutes ownership.