All entrepreneurs have had to consider various traditional and non-traditional (alternative) methods of funding over the time. Debt and equity are the two of the most common methods of funding a company can try for. In case of a debt, the start-up receives a loan of a certain amount that they have to pay back within a pre-decided period. In case of equity, the start-up offers a part of its (company) share to the investor in exchange for money. Convertible debt is something of a hybrid – the start-up receives it like a loan and has to pay an interest rate over the agreed-upon period. However, at the end of the term, the investors can choose to convert the debt into equity.

Here is a comprehensive comparison between the different pros and cons of equity, debt and convertible financing for start-ups.

Equity-based financing can go a long way

Start-ups can use equity to put a number of resources back into the business. Debt financing can restrict the cash flow of any start-up by imposing a compulsory payment structure. Equity financing makes the repayment options more relaxed and facilitates a more nurturing environment for the company to grow within a short period. This kind of financing is ideal for all companies where cash flow is unpredictable. Angel investors and venture capitalists are the main sources of equity financing for most growth companies of today. It offers a certainty of valuation for all start-ups. Hence, most new start-ups avoid equity financing since it may put a much lower price-tag on the company shares. Newer start-ups often prefer debt financing to avoid the legal risks of diluting the founders’ stakes.

The disadvantages of equity financing

Very simply speaking, the return of investment for each investor grows with the start-up. It is also true that the share of the investor also decides their importance in decision making. On the other hand, it can pose a greater threat to the investors since a start-up or a new company may choose not to repay the debt. Therefore, most equity deals require a lot of evaluation, and they usually take longer to close.

Debt financing to fuel your start-up dreams

Debt financing including venture debt is an easy option for new businesses and small start-ups. This form of financing follows the simple debt structure. The borrowing party pays the lender in easy monthly installments at a fixed rate or a floating rate of interest. Almost all venture debt financing options come with a fixed repayment term. When the start-up is considered naive and does not have a record of success, it is smarter to opt for debt financing since equity will likely devaluate future market shares. In case your start-up does not have a trailblazing track record in the last couple of months, you should consider debt financing instead of equity financing, irrespective of your business experience. In case the company goes bankrupt, these investors get priority.

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Beware of the drawbacks

Debt financing is not fool-proof either. It can leave the start-up rather vulnerable during the hard times, and there have been instances where a company has had to choose paying investors over scale-up options in the past. Debt financing is not always the best option for start-ups. However, it is one of the most popular funding options. Companies may need to liquidate their assets to pay their venture capitalists and investors. Banks can force start-ups to liquidate their assets in an attempt to recoup the amount. The interest rates can be dicey. Always check if you are getting fixed term interest rates or floating interest rates for your venture debt funds.

The best of both: convertible debt

Convertible debt or convertible note is the hybrid of the two most popular funding concepts. It is quite easy to realize, and it is also very inexpensive. It offers quick turnaround options to almost all start-ups in contrast to equity financing, which may require cascading legal procedures and added legal fees. Convertible debt does NOT require a monthly payment, just like equity funding. At the end of the particular loan period, the investors get a share of the company equity. It does not strap the start-up for cash, and there are no new cash flow constraints that can bind the start-up’s growth.

A mishmash of old and new disadvantages

Just like equity funding, the investors can set the equity terms during the conversion. Therefore, the investor and the start-up owners have no idea what the equity will look like until the agreed-upon milestone comes. Another huge disadvantage to the start-ups is that they have to accept the convertible loans at a discount, so the investors enjoy due preference for early investment actions. The start-up’s owners get very limited time before repayment term ends or the debt converts into a business share (equity).

Conclusion

A detailed comparison between Equity Financing and Debt Financing shows that none of them are perfect for funding start-ups. In fact, they are not perfect for financing any company irrespective of their age, field, nature, and market. Even the combination of the two – convertible financing is not a perfect funding solution.

There are several financing options for all kinds of businesses and start-ups. Today, start-ups and SMEs have more funding options than the mainstream larger corporations. Each funding option comes with its own set of advantages and disadvantages. Before you pick a financing company or an online lender who is willing to help you out, you need to seek the advice of an experienced finance lawyer or an investment expert. They have a better insight into all the existing financing options, and they can help you pick the option that is likely the best for your start-up’s future growth.