You’ve concluded that seeking outside investment is the best financing strategy for your business. You are confident that you will be able to access sufficient financing from outside investors, so what should your strategy be: debt or equity?
Debt or equity: Questions for you to consider
Most entrepreneurs generally use a combination of types of financing over the life of the business. In fact, certain types of loans will require that a business maintain a balance of equity and debt (called “leverage ratio”) that is appropriate for the stage of business and the industry in which it operates.
Advantages of debt versus equity
- Debt does not dilute the entrepreneur’s ownership position in the business.
- The lender is only entitled to repayment of the debt plus agreed-upon principal plus interest payments and has no claim on future profits of the business.
- Interest on the debt is a deductible expense of the business for tax purposes.
- Arranging debt financing is less complicated because the company is not required to comply with federal and provincial securities laws and regulations.
- The company is not required to send updates to shareholders, arrange shareholder meetings and seek the vote of shareholders before taking certain actions.
Disadvantages of debt versus equity
- Debt, unlike equity has to be repaid on a specific schedule.
- Interest is a fixed cost, which raises the company’s break-even point. High interest costs during difficult financial periods can increase the risk of insolvency.
- Cash flow, to cover both the operating expenses of the business and the principal and interest payments is required and must be planned for appropriately.
- A company with a larger debt/equity ratio is considered more risky by lenders and investors. Accordingly, a business is limited as to the amount of debt it can carry.
- The company is usually required to pledge assets of the company to a lender as collateral, and owners of the business (often in early-stage ventures) may be required to personally guarantee the repayment of the loan and interest.
Typical uses for equity and debt financing
- Short-term debt is used to finance assets that can be made liquid quickly (turned back into cash) – examples include accounts receivable amounts, tax credits, newly signed contracts and inventory.
- Long-term debt or term loans are used to finance assets with longer lives, such as capital equipment or the purchase of land and construction of a plant or building.
- Equity investment is usually required to fund the startup losses of a business as there is no track record of or any certainty that business will generate cash flow to fund debt and interest payments.
Other observations about financing your business idea
- Financial institutions don’t give loans for startup costs or the value of intellectual property unless an entrepreneur pledges personal assets as collateral for loan.
- Technology entrepreneurs don’t seek early-stage loans for their businesses, unless they are certain that business will generate cash flow to repay loan over term.
- Long-term debt and term loans are usually only available to later-stage companies with cash flow or sufficient equity investment to ensure repayment of loan. Smaller, earlier-stage companies with some equity may have access to Small Business Equipment Loans through a financial institution.
- Friends and family investors are usually the most willing investors for initial rounds of equity investment.
- Angel investors typically invest earlier in the life of a business than venture capital investors and also consider medium-growth potential businesses.
- Venture capital (VC) investors only invest in high-growth potential businesses that require a minimum level of capital (varies by firm, available on VC firm’s website)
- Smart entrepreneurs stretch their cash by bootstrapping where possible.
- Smart entrepreneurs apply for government programs that require matching funds to be provided by the business in order to qualify for programs to align with timing of cash equity investments.