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Debt vs equity startup financing

Whilst bootstrapping is popular amongst the startup community, in order to grow quickly a business needs to raise funds, which can then be put to use by investing in new technology and paying employee salaries before earnings have had chance to catch up.

There are two basic forms of financing available to businesses – debt and equity, and each option has pros and cons, so it is worth exploring which option is better in your specific situation.

Debt

Most people are pretty comfortable with the idea of debt by the time they leave university, with most of us turning to a student loan to pay for our studies – unless you have been lucky enough to get a scholarship likes those from Nationwide Debt Direct. Loans, credit cards, and bank overdrafts are common forms of consumer debt, and business debt works in much the same manner.

Friends, family, and banks are the most common source of debt financing, with businesses taking at loans for anything from a thousand pounds to many millions.

The main benefit of debt for a business owner is that they do not relinquish any control of their business, so just like with a credit card or a consumer loan from the bank, businesses simply have to repay the lender the amount the borrowed (plus interest). This means that if their business becomes hugely successful, they will not have to share the profits with shareholders and they can keep a greater proportion of the proceeds themselves.

Moreover, in contrast to share sales, there is little regulatory burden with raising debt, so companies can quickly and relatively easily obtain the funds they need – as long as someone is willing to lend it to them! There is no need for businesses to send regular updates to shareholders, and no need to seek the vote of shareholders before taking certain actions – as long as the loan is being repaid on time, that is all you need to worry about.

However, the more highly leveraged (debt-equity ratio) a company becomes, the less attractive they are to potential investors, and the regular payments are not forgiving of cashflow – so debt is not always the right choice. Additionally, most lenders will require companies to pledge assets or have business owners personally guarantee any loans, so their personal financial stability could be put on the line.

Equity

Selling shares gives a company the chance to raise large sums of money without the commitment of specific monthly repayments, but in return business owners give up a proportion of ownership and control of the company they have built.

Business angels and venture capitalists like those on Dragon’s Den or Shark Tank are looking to take equity stakes in companies, and the sums can be huge. The investors are looking to take a slice of the next big thing, as with an equity investment they will have a share of a company’s profits forever. The rewards for such investors can be huge if they back the right horse, but similarly they are taking on a significant amount of risk, as equity investments are not guaranteed by any assets – so if the company goes bust, the investors lose their entire stake.

Whilst traditionally businesses will look to individuals or small groups for equity investment, the last decade has seen the rise of crowd-funding sites, where businesses can raise larger funds because the risk is spread between a greater number of investors.

Whether you are looking to raise funds through debt or equity, it is crucial that you talk to an unbiased advisor, that, as the folks from Nationwide Debt Direct say, knows the “cycles, internal policies, and procedures that move these industries” to get the right option for you.

Photograph by Alexas Photos