Debt Vs Equity for Startups
Debt Vs Equity for Startups- Pros and Cons of both are covered in this article
Debt Vs Equity is a very logical comparison when a company thinks about raising funds to meet its capital needs. Very often we come across various funding news in leading newspapers and websites these days. Almost all these deals are equity investments through angel, venture capital and private equity investors (to know the various types of investors click types of startup investors). These investors are high-risk takers and have an investment horizon of around 5-10 years with a typical investment portfolio spread across various industries to reduce their risks. For example typically in a Series A round of funding, investors invest around $ 2-4 MM for 25-30% of the equity.
When the startup environment in a particular region is in nascent stages then equity investment is prevalent. However, as the environment of startups mature and valuation becomes saturated then debt financing becomes the need of the hour. The same trend has been followed in US where equity investment started actively in 1980s and debt financing in startups started in 1990s and now it is coming to India as well.
We have multiple billion-dollar valuation companies in India and from this point raising another round of equity with higher valuation becomes a challenge for these biggies. So these established startups with good PE investor funding starts looking for debt funding for their short-term working capital needs. In this article I will try to discuss the pros and cons of both equity and debt funding. Founders should choose the options very carefully as they might put their venture in grave danger with wrong choice of funding.
Equity is the preferred choice of the startups in their incipient stage as they do not have access to easy debt funding and they need good amount of funds for marketing and increasing their customer base etc.. With the help of equity they improve on their product, hire experienced professional from industry, increase their marketing budget, expands to more areas, expands their category portfolio, improves customer service etc. But all these goodies come at a cost and the cost is loosing ownership of your company. (To top the investor’s favourite list of startups please check –what investors look for in a business before investing).
Pros of equity funding:
1. No worry of returning the money back–
Best part of the equity investment is that the founders need not have to worry about repaying the money back. Founders and equity investors are sitting in the same boat and equity investors are looking for their high value exits. These exists can be in the form of next round of funding with higher valuation, acquisition of the company and IPO (Company going Public on stock market).
2. Funding at much needed time-
Equity investors gives funding when the startup has just started and needs funds to improve on their product, expand its reach and customer base etc.
Cons of equity funding:
1. Funding at a cost of company control–
In a typical seed funding round a startups looses 10-20% of the company control and with another Series A funding they loose another 15-25% of the control.
2. You are now answerable to the investors–
It’s not about loosing control only with the participation of equity investors there comes lot of covenants and conditions that your company has to satisfy from time to time. Founders have to keep updated the investors on all aspects of the company including the proposed budget on various activities and divisions. It is not that easy to run the Company as the founders used to do in their initial stages. There are various checks and balances with lot of monthly and quarterly reporting.
Once the startup environment gets mature enough with some good number of multi billion valuation companies then Venture Debt Capital Market becomes activated. Here I am talking about a loan given to a startup which is around 2-4 year old and has already received Series A funding from a respected Private Equity. All these things give some sort of confidence to venture debt investors.
Apart from the two conditions mentioned above companies should only raise venture debt when they have some clarity in their future cash flows and financial projections. Companies have to pay back the debt amount in a particular tenure of time along with interest.
Lots of matured startups in India are now looking for Venture debt like Freecharge, Mobikvik, Snapdeal, Myntra, Firstcry etc. Mobivik raised $ 100 mn from a consortium of lenders led by Tennenbaum Capital Partners (US based), according to ET. Flipkart is also planning to raise debt for the first time in the form of rupee bonds worth Rs. 3000cr.
Pros of debt funding:
1. No dilution of equity:
Companies need not dilute their equity stakes for raising debt. Although there is equity warrant clause in venture debt, which allows venture debt funds options to participate up to 1-5% of the loan amount in case of another round of funding or acquisition of startup.
2. Buffer time:
Venture debt gives companies time to raise next funding round from PE investors. In this way they can negotiate their valuation and terms in a much better way, as they are not running out of time.
Raising funds for working capital needs at the cost of loosing equity is not justified. As working capital is a cash flow mismatch of 3-6 months and loosing control of the company for that is not a wise decision.
Cons of debt funding
1. Predicting Future is quiet Tough–
Founders need to be pretty sure about the future position of their company in term of cash flows and profit margins, which is very difficult in such a challenging and dynamic environment of startups. They have to mandatorily repay the debt amount with interest on monthly or quarterly basis. If they fail to do so they can go under litigations and bankruptcy.
2. Increases your work pressure–
Raising debts put some extra pressure on the company in terms of interest expense, which is in the range of 15-30%, but this is at the cost of not loosing control in the company.
Founders have to make best decisions for their company in terms of debt vs. equity funding. But the above few points should be considered before raising next round of funding for their startup.