The psyche of a startup founder when it comes to financing is an interesting … mess. On one hand, you need money to validate your product-market fit, get prototype to market, make key hires, and grow like a weed. One the other hand, you want to keep as much of the pie as you can, not be unduly restricted in making future decisions and reduce personal exposure. You want to make sure you're taking smart money for the stage of growth you're at.
So, what’s the best financing option for your company? Sometimes it feels like the "colour" of the money isn't important. However, each type of financing has different strings attached. This is a big topic, so for the purposes of this article, we'll focus on the basics: debt and equity. The title suggests competition between the two options, but really debt and equity can be used together at various, maybe alternating, stages to fund a startup or scale-up
There are a spectrum of costs and benefits to both. Let’s have a look:
Equity – "Patient capital"
Equity is a stake in a company obtained in exchange for money. When buying equity, an investor is generally is making a sophisticated bet on a company at its early stages, or during high-growth period, without a clear plan for how it will get paid back, but with the expectation that there will someday be a big return. The company will need a clear plan for scalability, even if it isn’t fully validated. For the investor, there’s high risk, high reward.
Often entrepreneurs balk at “giving away too much equity.” Indeed, ownership is an important consideration in order to keep the founders and team motivated by the potential for their ownership growth, as well as the need to use equity for future financing. However, it's equally important to understand investor interests and risk – they’re taking their limited resource (cash) and putting it into your hopes and dreams with limited operational control.
There is a risk/return scale at work here: An equity investor is willing to give you, the entrepreneur, more money than you might otherwise have access to (through debt, for example), with fewer requirements for payback, in exchange for big upside potential (through ownership). One way for entrepreneurs to gain a level of comfort with “giving up” an ownership slice, is to view equity financing as a purchase of capital in exchange for an investor’s expertise, experience or network. Ideally, the exchange shouldn't be transactional, but rather relationship based. Keep in mind that once you “purchase their capital” your company is is now a shared business. It’s “we” not “me” when you take on investors.
For a tech company, equity financing should be focused on fueling rapid growth or deep innovation at a time when the company needs significant capital relative to its current revenue or enterprise value. Not all equity is the same however, so be prepared to learn what industry standards are for the stage you're at by speaking to your lawyer, accountant and peers.
Pros: Bigger cheques (as a fundraising round), patient capital allowing decisions that are right for driving the company's long-term value; often comes with strategic advice and networks.
Cons: Takes time to raise; shareholder dilution; if investors are not aligned to the business plan they can put undue pressure on management about the operation and direction.
Debt – "The repayable loan"
Debt is a great, non-dilutive instrument to help you through a variety of situations, including financing your company’s operations between equity rounds. Debt is always repayable on some pre-negotiated schedule, typically comes with an interest rate and/or some sort of fees, and requires a company to show either historical financial performance or forecast financials that give lenders a degree of comfort that it will get paid back. Generally speaking, debt is a much more conservative approach than equity, but many lenders, including BDC, are working hard to get more comfortable with the elements of risk involved with a tech company, and the idea that debt may be repayable through some means other than positive cash flow – the traditional approach to banking.
Debt most often requires a company to be generating revenue and/or have some asset to secure the loan, or have demonstrated how future revenues will continue growing. The benefit of debt is that it usually doesn't require any equity to be given up, and that it can extend runway or fuel sales growth in order to increase valuation in preparation for a necessary future equity raise. You always know where you stand with debt, as well. The cost and repayment is calculated before you commit.
While impossible to predict all future outcomes, be sure you understand your potential funding pathways throughout the lifecycle of your business. Too much debt, too early, can be a deterrent for equity investors in future raise periods if their money would be required to pay out the debt rather than fuel growth. Both can work well together, but understanding balance and the funding roadmap are key.
Pros: Non-dilutive; less effort to acquire; established lenders with clear interests; planned repayment; lower return payout (in the event of success).
Cons: Restrictive conditions or rules about what you can do with the money; required regular repayment; interest accumulation; consequences of non-repayment.
Conclusion
Ultimately, if you're a high-risk situation (ie. you haven't yet demonstrated market validation and are not forecasting an ability to repay debt in the near term) you'll need to find equity financing. If you're in a stable place where revenues and forecast look like they can service debt while you continue to grow the business, you can seek non-dilutive debt options.
There are many sources of debt and equity in Canada and abroad, and today you'll find more available capital than ever before, but the competition for the same dollars is also on the rise, so it’s important to make sure your ducks are in a row before you start sending around investment memos.
Banknotes is an occasional column offering financial advice to startups.
