Growth Gears: Equity vs. Debt - Fueling a Startup’s Journey

Hello friends and welcome back to the Product in Public newsletter, where I give you an inside look at how I help companies attract capital and build better products.

Before we get to today's newsletter, here’s some of the content I’m consuming that you might find interesting.

What I’m consuming

The Mrs. and I spend dedicated time together through two channels: walks and watching shows.

Our current show is 007 - Road to a Million. It’s a James Bond-themed adventure race/trivia challenge.

What has been the most fun aspect of the show for me is watching the relationship between the pair of people in the group.

There’s the Bone brothers who work surprisingly well together. The two nurses who, as I’m learning about most nurses, are virtually unshakeable.

Give it a go if you are looking for something new to binge. You can find it on Amazon.

Dreams need fuel.

But the type of fuel you use matters.

With vehicles, you can’t put diesel in a car that runs on regular gas.

The same is true for growing businesses. The type of growth funding you leverage depends on a variety of factors.

The key is to understand the differences between equity and debt financing, and when each is appropriate for your business.

Equity Financing = someone else owns a piece of your business

When you take on investors you are giving them ownership in your business. Even if you maintain the controlling interest, you still have people involved who will feel like they need a voice regarding how the business is run.

There are some positives to equity finance.

Unlike a loan, equity financing doesn’t burden you with fixed repayments. Investors get back if/when the business is profitable and/or through an exit.
Because equity financing generally involves more risk, there is usually a potential for a higher rate of return for the investor.
If you take on the right investors, you are not only getting access to capital, but you are also adding the investor's expertise and network to your resources.

Tradeoffs do exist.

Investors will require a voice in your decision-making, often by being added to your Board.
Investors will scrutinize how you are operating as a leader and the decisions you make.
Dilution occurs. There will be less upside for you as a founder because investors are due their share of any gains. Dilution will likely occur multiple times, as most equity-financed startups require multiple rounds of funding to reach an exit.

Debt Financing = a pile of cash in return for regular payments

When you get a business loan you are getting cash upfront, but the lender expects you to repay that loan, plus interest, over a period of time.

Loans can be attractive because:

you maintain control of your business. The lender won’t own a single share.
there are programs, like SBA loans, that make it easier to get approved.
they improve your creditworthiness, which makes future loans easier to get.

But, debt brings challenges.

Your loan payments aren’t negotiable and those payments are stripping cash flow out of your company that could be used to fund growth.
The days of cheap capital are behind us. You should expect your interest rate on a business loan to be north of 8%-12%, on average.
If you default, the lender can hold you personally liable for what they are owed. This is a big one to consider.

Choosing Your Funding Fighter

To figure out which financing method is best for your business, consider these factors.

Stage of business - early-stage ventures that are not producing enough cash flow to afford loan payments will need investor funding.
Creditworthiness - if you as a founder have credit issues then getting a loan could be tough.
Growth Plans - equity financing works best for fast-growth ventures as lenders may struggle to keep up with capital-intensive business models.
Risk Tolerance - would you rather have the burden of making payments every month and being personally liable for a loan or have the pressure that comes with investors being in your business?

Three Case Studies

Let’s compare three separate scenarios.

I talked with one founder this week who has a novel idea for creating building materials out of waste. The venture is at the ideation stage and is pre-revenue. This one should be an easy answer for you - equity financing is her only real option.

Another founder has a successful exit under his belt. This time around he is looking to acquire a business, in the same space as his previous company. The business he is acquiring is decades old and is putting off good cash flow - debt financing is the choice here.

The final founder I spoke to has a retail business that is doing well. It is putting off a lot of cash flow and he is ready to expand. But, not by just a few stores. He plans to open at least five simultaneously. On top of that, he is looking to turn the model into a franchise opportunity. Because the business is cash-flowing well, you might think debt finance is the best option. Add to that the founder doesn’t love the idea of giving up equity in his venture. The challenge is his growth expectations are such that he will quickly eat through his cash and even if a lender would help him initially, its likely that a lender would balk at the pace of new debt financing he will need. So, my advice was to go the equity route. Although he will have to give up some ownership, the amount of shares should be limited since he has a successful business, i.e. the more traction a business has the better the valuation and the more ownership a founder can retain with investors.

Funding Your Future

Not every business needs capital to grow. For those that do, equity and debt financing can be powerful tools. By understanding the nuances of each option and considering your preferences, you can find the right growth gears.